Backwardation of Option Pricing

Options Trading Topic: Backwardation of Option Pricing

Dear Options Trading FAQ:

Perhaps you can explain two recent closing option prices that just don't seem to make sense to me. I noticed that the last transaction for SIII Dec. 20 call options was $1.00. The closing price on the same day for the Jan 20 calls was 7/16. Why in the world would there not be a greater premium on the farther out January call option?

Thought Time was Precious with Options

Dear Option Timer:

I think the key words in your question are: LAST TRANSACTION. In talking about options, we really must look at last bid/asks and not closing prices. In inactively traded options (i.e. options other than OEX and SPX) or strikes, there is often a drastic difference between the last transaction price and the current bid and ask.

In your particular example, I would guess that the January call options have not traded for a while. If you look at the closing bids, you'll see prices that make more sense.

There actually are instances where the option with a shorter time to expiration will trade for more than one with a longer contract life. Every once in a while, I'll see a question about this.

The last time it was brought up, it was seen in far-out-in-time, deep-in-the-money SPX options. How can this be? As you point out, shouldn't the extra time mean something? Well, this phenomenon (known colloquially as backwardation) has to do with the cost of carry of these pricey options. Certain strategies will call for purchase of nearer term options and this greater demand will actually leave a inversion in the normal relationship. An interesting oddity - maybe it can be exploited.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Pricing, Options Valuation

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