InvestorQ : What happens to the price of a call option if the exercise price of the call option contract is moved down lower?
swati Bakhda made post

What happens to the price of a call option if the exercise price of the call option contract is moved down lower?

Answer
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1 year ago


The exercise price or the strike price is the price at which you contract to buy or sell the asset. In case of a call option, the exercise price or the strike price is the price at which you have contracted to buy the particular stock. Let us look at the impact of the above shift downward in exercise price on the value of the call option.

Input Data

Input Data

Stock Price now (P)

120.00

Stock Price now (P)

120.00

Exercise Price of Option (EX)

125.00

Exercise Price of Option (EX)

120.00

Number of periods to Exercise in years (t)

0.08333

Number of periods to Exercise in years (t)

0.08333

Compounded Risk-Free Interest Rate (rf)

5.00%

Compounded Risk-Free Interest Rate (rf)

5.00%

Standard Deviation (annualized s)

30.00%

Standard Deviation (annualized s)

30.00%

Output Data

Output Data

Present Value of Exercise Price (PV(EX))

124.4803

Present Value of Exercise Price (PV(EX))

119.5010

s*t^.5

0.0866

s*t^.5

0.0866

d1

-0.3800

d1

0.0914

d2

-0.4666

d2

0.0048

Delta N(d1) Normal Cumulative Density Function

0.3520

Delta N(d1) Normal Cumulative Density Function

0.5364

Bank Loan N(d2)*PV(EX)

39.8844

Bank Loan N(d2)*PV(EX)

59.9799

Value of Call

2.3542

Value of Call

4.3903

(Note - Period is reduced to yearly decimals

In the above instance we have moved one notch lower on the call option from a 125 strike to a 120 strike. What happens to the value of the call option? There is a sharp increase in the value of the call option. Why is that so? A call option value is based on the positive gap between the stock price and the exercise price. When the exercise price or strike price is moved one notch lower, either the positive gap increases or the negative gap reduces. Either way it is positive for the value of the call option. That explains why the value of the call option has risen in the above case when the exercise price has moved down by one notch.