I've been reading Sheldon Natenberg's Option Volatility and Pricing book, which was recommended in a couple of threads on T2W that I read recently (bv robertral and RogerM, to name but two)
So far, so good - it's a very thorough book and has already cleared up several misunderstandings I had about option (and by implication, covered warrant) pricing.
However, there's one comment in one of the early chapters that stopped me in my tracks, where he says that "intrinsic value can't be negative" or words to that effect.
So, if I have an underlying a 1000p Call on an underlying at 980, which is currently trading at 27p, this would be 20p intrinsic with 7p time value.
But if in the same set-up, but with the underlying at 1020 and the option at say 4p, he would have the intrinsic as 0p and the time value as -16p. I have always thought that this situation would have an intrinsic of -20p and time value of 4p.
His view seems illogical to me - surely if the time value is negative, this is saying that the chance of the option finishing in profit is less than zero? Which seems, at best, counter-intuitive, and at worst, plain wrong.
So, bearing in mind that he's a well-respected author, and I know nothing, which of us is "right"?
If he's is "right" (ie the generally accepted view), can someone please explain the logic of this view?
(On another tack entirely, for anyone reading this book, I would also recommend a copy of Buying and selling volatility by Kevin Connolly - there is a throw-away comment about hedging that isn't (yet?) covered in the Natenberg book which is covered in exhaustive detail in the Connolly book. Generally, the two books complement each other well, without too much duplication. Advert over)
So far, so good - it's a very thorough book and has already cleared up several misunderstandings I had about option (and by implication, covered warrant) pricing.
However, there's one comment in one of the early chapters that stopped me in my tracks, where he says that "intrinsic value can't be negative" or words to that effect.
So, if I have an underlying a 1000p Call on an underlying at 980, which is currently trading at 27p, this would be 20p intrinsic with 7p time value.
But if in the same set-up, but with the underlying at 1020 and the option at say 4p, he would have the intrinsic as 0p and the time value as -16p. I have always thought that this situation would have an intrinsic of -20p and time value of 4p.
His view seems illogical to me - surely if the time value is negative, this is saying that the chance of the option finishing in profit is less than zero? Which seems, at best, counter-intuitive, and at worst, plain wrong.
So, bearing in mind that he's a well-respected author, and I know nothing, which of us is "right"?
If he's is "right" (ie the generally accepted view), can someone please explain the logic of this view?
(On another tack entirely, for anyone reading this book, I would also recommend a copy of Buying and selling volatility by Kevin Connolly - there is a throw-away comment about hedging that isn't (yet?) covered in the Natenberg book which is covered in exhaustive detail in the Connolly book. Generally, the two books complement each other well, without too much duplication. Advert over)
