I'm sure we have all traded a call option that declined in value when the stock was on the rise. I know I have done it many times before I started focusing mostly on option selling strategies. We all know that stocks and options are completely different investment vehicles.
What's hard about the question above is that a stock's price is just one of 7 factors that effect the price of an option. And usually this question is asked by newbie options traders, but I've seen seasoned pros even mess up. That's because option pricing is tricky and can be downright confusing without some simple guidelines to follow.
This Is NOT Uncommon
At first it may seem like something is going wrong. You thought the stock would rally and so you bought a call. Now the stock is higher (as you predicted) and yet you're losing money! What's going on right?
I can assure you that it's not uncommon to have this happen. In fact this happens each month to thousands of traders. That’s why knowing the ingredients of stock option pricing is so critical to your success.
So let’s get started...
Stock Price And Strike Price Relationship
This is the most important factor when determining the value of a stock option. The strike price is the price that a call buyer may purchase the shares at or before expiration.
When the stock price is above the strike price, a call is considered in the money (ITM). The situation is reversed when the strike price exceeds stock price — a call is then considered out of the money (OTM). An at-the-money option (ATM) is one whose strike price equals (or nearly equals) the stock price.
So the first reason why your call option could be losing money is because the stock price is not above the strike price. If the OTM option you own has no intrinsic value, its price consists entirely of time value and volatility premium.
Time Value Decreases Rapidly
Time value is your worst enemy as an option buyer because it erodes the value of your call option each and every day. Therefore, an option’s value at expiration is only the amount it is in the money (ITM).
Stock traders don’t have to worry about time value because they can own as stock for years (and even decades). But options have a finite life that ends at expiration. So it's make it or break it for the stock price to rise higher than your strike price before time decay eats away at the value of your option.
Decreased Market Volatility
As I mentioned above, OTM options are made up of mostly time value and volatility premium. Volatility is simply the propensity of the underlying stock to fluctuate in price. The more volatile a stock the higher the chances of it "swinging" towards your strike price.
The higher the overall implied volatility, or Vega, the more value an option receives. Generally speaking, if implied volatility decreases then your call option could lose value even if the stock rallies.
Underlying Stock Dividends
Dividends increase the attractiveness of holding stock rather than buying calls. This is because call buyers are not entitled to the dividends until they actually own the stock. You can't have your cake and eat it too right! Therefore, larger dividends reduce call prices overall.
Interest Rate Effects
I bet you never thought interest rates effect an option's price right? Well they do to a certain extend and it's another Greek - Rho. As interest rates rise (which is ironically what will happen in the near future) this helps call option premiums.
Higher rates increase the underlying stock’s forward price (the stock price plus the risk-free interest rate). If the stock's forward price increases then the stock gets closer to your strike price, which we know from above helps increase the value of your call option. On the flip side, decreasing interest rates hurt call option owners.
Share A Trading Story
Not one person has ever traded options and NOT had this happen. Share your story via the Facebook Comments below and tell me what you learned from the experience. Did you choose to start buying options ITM or ATM instead of OTM? Or maybe you are not playing volatility?