How Options Can Lose Money, Even When You’re Right!

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 sucker punched by the fact they just lost money on a trade they thought was going to fund their big trip to the Caymans! 

Here are the two situations where this occurs:

  1. With a call option - you purchase the call, stock goes up, and the call goes down
  2. With a put option - your purchase the put, stock goes down, and the put goes down

FRUSTRATING!

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.

  • The volatility changes
  • Buying out of the money options
  • Wide Bid/Ask spread

We are going to look at each of these: 

Volatility Changes

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, sometimes without warning. These IV changes can wreck havoc on your option price. 

As the IV changes, the price will change as well. Increasing in price if the IV goes up, and decreasing in price if the IV 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 IV has been as high as 64, almost 65, and actually below 35, all in the last 90 days. Currently, the IV 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.

  • Vega = 0.039
  • IV = 44.39
  • Current price = $1.72.

Based on these numbers, we can do some pretty straight forward calculations and get some very good ideas of the impact of IV on the price.

If you track the math above, using the numbers in the chain, if the IV 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 IV!

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 IV representing more than 30 points! This impact is real, and it can wreck havoc on your option price. 

 

Buying Out of the money options

Buying out of the money (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 however much instrinsic value it 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 it's 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 devestating 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 do so 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 that the trade will go up to around $46. This is a reasonable trade. 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. 

Why? 

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! 

Wide Bid/Ask Spread

Sometimes it appears you have lost money when in reality you just made a really 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 gets widened 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 ($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 just need to use a limit order and set the price somewhere in the middle of the spread.

Wrap Up

Stock options can be a wonderful trading tool. They can provide leverage, they can help increase profits, and help decrease risk. But they do not come without some baggage. They can be difficult to understand, and failure to understand them can actually lead to a loss, even though you were completely correct in your analysis and general trade setup!

Here we have discussed three areas where traders get caught losing money when in reality, they should have made money. If you will avoid these mistakes and continue to educate yourself on the interworkings of options and option pricing, the reality is the benefits of options still far outweigh the drawdowns.

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