Have you ever bought an option, watched the stock move in your direction, up for a call option and down for a put option, and then noticed your option went down in price? You wonder to yourself how this could be. While no one likes to feel confused about their account balance, there are a few everyday situations that could explain why this happens, such as time decay, implied volatility, and a wide bid/ask spread.
As options traders, we understand options run out of time and will eventually expire. However, not every new options trader knows what this means. Simply put, every day, your option premium is losing money. This results in the phenomenon known as Time Decay.
It should be noted that only the premium portion of the option is subject to time decay, and it decays faster the closer you get to expiration. Intrinsic value which is, the value any given option would have if it were exercised today, is not affected.
1. Buy 1-2 strike prices In The Money but only when the market is above the strike price.
2. Buy four weeks more time than we expect to need in the option.
By putting these two boundaries on our options trades, we remove a significant portion of time decay exposure.
Regrettably, what often happens is that an options trader will buy 1-2 strike prices out of the money and hope the trade goes up. Then they discover that even though the trade moves up, it may not keep pace with Time Decay. This can create a scenario where the stock may move in the right direction, but the option will still lose value, making it much harder to profit.
I consider Implied Volatility or IV and its partner Vega hidden threats to options. Implied Volatility or IV is a measurement of the extra value built into the price of an option to offset potential price fluctuations in the future. We like to call that fluff, and the greater the uncertainty of price movement in the future, the bigger the fluff.
As for Vega, it is a time-sensitive measure, in cents, of the amount an option contract's value changes in reaction to a 1% change in the implied volatility of the underlying security. IV is a component of premium pricing, and for better or worse, it can change rapidly. When implied volatility changes, it impacts the option premium by the amount indicated in your option chain's Vega column.
Therefore, if the option has a vega of .08 and the implied volatility goes up by 1 point, the option will increase by .08. If the option implied volatility goes down by 10 points, the option price will go down by .80!
The above scenario is common around earnings season, and it can play out like this:
As the stock is getting closer to reporting earnings, the option implied volatility is slowly "ramped up." This accounts for the uncertain nature of the impending earnings release.
Then, much to the surprise of many option traders, the earnings announcement is released. The implied volatility returns to normal, which has an immediate negative impact on the option premium.
Another great example to keep in mind was the GameStop short-squeeze we experienced back in January 2021. During this unique event, some option IV temporarily skyrocketed to 600% or more!
If you owned options before the frenzy, their value skyrocketed even more as IV exploded upward. However, a problem then occurred when that IV came crashing back down. It destroyed the value of options that were purchased during the frenzy at ridiculous IV levels. Unknowing options traders paid a high price.
IV can have a sizable impact on an option premium. Many options traders have fallen victim to the assumption of a significant earnings trade, only to find they were right on the move but wrong on the option. All because they failed to understand the impact of volatility.
When an option moves deep In The Money, it becomes less attractive to speculators. As a result, there is less volume on the option, which can lead market makers to widen the Bid/Ask spread of the option. Then before you know it, your account balance looks like your option is losing money when, in fact, it is not. How is this possible?
Account balances are based on the last price that an instrument trades. However, with options that are deep in the money, the last trade may have been a long time ago. This makes the last price look drastically different than the current quote.
Consider these deep-in-the-money options on FDX. The stock was trading here at $154.28; however, you can see the $170 Put options still have plenty of open interest but no volume. If you look at the last price, you will notice it is substantially different than the current Bid/Ask.
Imagine you own a few contracts of the $170 put option. You have over $15 of intrinsic value, but the last price is less than the current intrinsic value. This will mess up your account balance and lead you to believe your account is going the wrong way when in fact, you were correct in the trade. Plus, if you wanted to sell even at a market order, you would have much more profit in the trade than the balance sheet is reflecting.
Checking to see the most recent trade price was and when that last trade occurred can be a quick, easy way to put your anxieties to rest when your account balance seems off. Especially for newer options traders, it can be easy to look at your account balance and assume it reflects the most current information. And much of the time, it does! However, if something looks odd or strange, it's usually worth digging a little deeper.
Next time your stock price movement surprises you, review this article and ask yourself whether Time Decay, Implied Volatility, or a Wide Bid/Ask Spread could be the culprit!