Have you ever bought options, watched the stock do exactly what you expected, and gone back to sell only to discover it is now worthless? Option pricing can be a bit complicated and as a result, can sometimes leave traders feeling a bit frustrated by the fact they just lost money on a trade they thought was going to end up on the plus side.
Here are the two situations where this occurs:
There are three underlying causes that can cause this situation to occur. These underlying causes apply equally to the call scenario and the put scenario.
We are going to look at each of these:
Implied volatility (IV) can change very quickly on an option. Typically, these fast changes occur surrounding earnings dates or other big announcements, but they can occur at any time and sometimes without warning. These implied volatility changes can cause chaos on your option price.
As the implied volatility changes, the price will change as well. It is increasing in price if the implied volatility goes up and decreasing in price if the implied volatility goes down. To better forecast the impact that will be had from such a sudden change, you can look at the vega value in your option chain. Vega is the amount of impact a 1-point change in implied volatility will have on the premium of an option.
Take a look at this volatility chart of FSLR:
Notice the implied volatility has been as high as 64, almost 65, and actually below 35, all in the last 90 days. Currently, the implied volatility is holding in the mid-40s.
Take a look at the option chain to see the potential impact:
Here you can see all of the critical numbers.
Based on these numbers, we can do some pretty straight forward calculations and get some very good ideas of the impact of implied volatility on the price.
If you track the math above, using the numbers in the chain if the implied volatility increased by 20 points to 64.39 it would lead to an immediate $0.78 increase in the option price. This represents a 45% increase in option price, and it does not even require the stock price to change.
That is the power of implied volatility. This may seem extreme to you, but I'd like to remind you, on this chart of FSLR in just the last 90 days, we have seen a swing of implied volatility representing more than 30 point. This impact is real, and it can wreak havoc on your option price.
Buying out of the money or OTM options is another reason people lose money, even though the stock went the direction they wanted. This is a very common mistake, which, unfortunately, is widely circulated as the right way to trade options. It is, however, a trap that can cost you greatly.
The real value of an option is how much intrinsic value the option has. At expiration, intrinsic value is the only value that remains. Consequently, at expiration, you need this option to have at least as much intrinsic value as you paid for its total value when purchased.
If you start a trade with an OTM option, you have set the tables against you because now the trade has to make up for the lack of intrinsic value. As a result, option time decay can have a devastating impact that will leave your option worth nothing, even if the underlying stock does what you think it should do.
Even if the stock moves in your favor but does not move enough to offset your option premium, you will end up losing money on this trade.
On this HAL chart, you might consider buying a call option with the thoughts the trade will go up to around $46. This is a reasonable trade, and I would suggest you consider the $42 call option. But a lot of people will instead choose to trade the $45 call option, just a little out of the money but one that will be in the money if the stock gets to your target.
You can see the cost difference in the $42, $43, and $45 call options on this option chain:
It is approximately half the price to buy a $45 call vs. a $43 call, and even a larger discrepancy when compared to the $42 call. For many traders, they assume the $45 call is a better choice because it would provide better leverage if the trade makes it to $46. However, it can also lead to a much faster loss of capital, one that could hurt even if the stock goes up.
Look at what happened to this trade:
Even though the stock has gone up $2/share over a couple of weeks, the $45 call is still not in the money. You are now approaching expiration, must close the option, the stock has done what you thought, just slower, and your option is going to be close to worthless.
All because you purchased an out of the money option. The same trade, with a $42 call, would reflect an additional $2 of intrinsic value, and therefore turn into a profit when the $45 call would have left you broke.
Sometimes it appears you have lost money when, in reality, you just made a great trade.
When you start your option trades, you are likely trading at the money, or very near the money options. These options will have more volume, open interest, and general trading attention. As the trade becomes very profitable, however, your option may move from being 1-2 strike prices ITM into a deep in the money option.
When an option is $10-15 or more in the money, it attracts much fewer traders, and as a result, the bid/ask spread widens out as the market makers are trying to attract market players to those contracts.
Look at the following option chain and notice the ATM options only have a .20 spread, whereas the $80 option, which is $15 ITM has a $1.00 spread between the bid and the ask.
This spread can be very deceptive. If you are holding an option that deep in the money, it may appear you have lost some money. In reality, you can still close your trade; you need to use a limit order and set the price somewhere in the middle of the spread.
Stock options can be a wonderful trading tool as they can provide leverage; they can help increase profits and help decrease risk. But they do come with some inherent limitations as they can be difficult to understand, and failure to understand them can lead to a loss, even though you were completely correct in your analysis and general trade setup. However, if you will avoid these mistakes and continue to educate yourself on the inner workings of options and option pricing, the reality is the benefits of options still far outweigh the drawbacks.
Expand your flexibility and create additional opportunities.