Why Are Calls More Expensive Than Puts?
Uncover the financial and market dynamics that explain why call options often cost more than put options. Understand complex option pricing.
Uncover the financial and market dynamics that explain why call options often cost more than put options. Understand complex option pricing.
Call options can sometimes appear more expensive than put options, even with similar strike prices and expiration dates. Option pricing is a multifaceted process, influenced by a dynamic interplay of financial and market variables. This article explores the various factors that contribute to this phenomenon.
An option’s total price, or premium, has two primary elements: intrinsic value and extrinsic value. Intrinsic value represents the immediate profit if an option were exercised today. For a call option, this is the amount the underlying asset’s price exceeds the strike price. For a put option, it is the amount the strike price exceeds the underlying asset’s price. If an option has no immediate profit, its intrinsic value is zero.
Extrinsic value, also known as time value, is the portion of an option’s premium beyond its intrinsic value. This value reflects the market’s expectation of the underlying asset’s potential price movement before the option’s expiration. Factors like time remaining until expiration and expected future volatility significantly influence extrinsic value.
As an option approaches its expiration date, its extrinsic value diminishes through time decay, or theta. This decay accelerates as expiration nears, especially for at-the-money options. The combination of intrinsic and extrinsic value determines the total premium paid for an option.
Prevailing interest rates influence the pricing of call and put options differently. For call options, higher interest rates generally increase their value. This is because holding a call option defers the cost of purchasing the underlying stock, similar to buying on margin without immediate borrowing costs. Higher interest rates make this deferral more attractive, as the opportunity cost of holding cash or borrowing to buy the stock directly increases.
Conversely, higher interest rates typically decrease the theoretical value of put options. Owning a put option is similar to shorting the stock and holding the proceeds, thereby earning interest. If interest rates rise, the theoretical interest earned on the proceeds from a hypothetical short sale increases, making the put option less valuable. This effect contributes to calls being relatively more attractive and puts less so in a higher interest rate environment.
Expected dividend payments on an underlying stock significantly affect option prices. When a stock pays a dividend, its price is expected to decrease by the dividend amount on the ex-dividend date. This anticipated price drop has opposing effects on call and put options.
For call options, this expected price decline negatively impacts their value. A call option’s profitability relies on the underlying stock’s price increasing, or at least remaining stable, above the strike price. The forecasted reduction in the stock price due to a dividend payment reduces the potential for a call option to gain intrinsic value, making calls on dividend-paying stocks generally less expensive.
Conversely, this same expected price drop positively influences the value of put options. A put option benefits when the underlying stock’s price falls below its strike price. The anticipated decrease in the stock’s value on the ex-dividend date increases the likelihood of a put option moving into the money or increasing its intrinsic value. Consequently, put options on dividend-paying stocks are typically priced higher to account for this increased potential for profit.
Implied volatility (IV) represents the market’s expectation of future price fluctuations for an underlying asset. Higher implied volatility generally leads to higher option premiums for both calls and puts, reflecting a greater perceived chance of significant price movements. However, implied volatility is not uniform across all strike prices for a given expiration, leading to “volatility skew” or “volatility smirk.”
In equity markets, out-of-the-money (OTM) put options often exhibit higher implied volatility than out-of-the-money call options. This skew typically manifests as a “smirk” shape when implied volatilities are plotted against strike prices. The existence of this skew is largely attributed to investor demand for downside protection, as market participants are often willing to pay more for options that hedge against sudden and significant market declines.
This increased demand for OTM puts, driven by a desire for portfolio insurance, drives up their prices and, consequently, their implied volatility. While OTM puts may have higher implied volatility, the overall market structure, characterized by a long-term upward bias in equity prices, means that calls can still appear more expensive for comparable situations.
Equity markets historically demonstrate an upward bias over extended periods. This tendency for stock prices to generally increase means the probability of a stock rising is often perceived as greater than a significant, sustained decline. This long-term directional bias influences option pricing, as the potential for substantial upside gains, which call options are designed to capture, is often valued more highly.
Investor psychology and sentiment also play a role in shaping option prices. Market participants are often driven by a desire to participate in potential upside gains. This demand for upside exposure can lead to increased buying interest in call options, especially for smaller or more speculative positions. This imbalance in demand, where there is a strong preference for capturing gains, can contribute to calls being relatively more expensive than puts.
The collective influence of interest rates, dividend expectations, the shape of implied volatility (skew), the market’s inherent upward drift, and investor behavior all contribute to call options sometimes being more expensive than put options. Each of these factors interacts dynamically, creating a complex pricing environment where the relative value of calls and puts is continuously adjusted by market forces and participant expectations.