Have you ever bought an option, watched the trade go in your direction, up for a call option and down for a put option, then noticed your option went down in price? How could this be? There are a few situations which could account for this happening.
As an option trader, we understand options run out of time and eventually expire. Unfortunately, not every new option trader knows what this means. It means every day; your option premium is going to lose money. Now it should be noted only the premium portion of the option is subject to time decay and that time decays faster the closer you get to expiration. Also, intrinsic value is not affected by time decay.
Taking these factors into consideration, we can set the trade more in our favor by simply following two rules: buy one to two strike prices in the money and buy four weeks more time than we expect to need in the option. By putting these two boundaries on our option trades, we remove a good portion of exposure to time decay.
Regrettably, what often happens is an option trader will buy one to two strike prices out of the money and hope the trade goes up. Then they discover, even though the trade moves up, it may not move as fast as time decay, which in turn, makes it much more difficult to profit on the option as it creates a scenario where the stock can move in the right direction, and the option will still lose value.
There is a hidden threat to options that shows up in the form of implied volatility. If you look at the greeks of your option, you will see a couple of interesting values, one is the “IV” or Implied Volatility and the other is Vega.
Implied volatility is a component of the 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 the vega column of your option chain. Therefore, if you have a vega of .08 and your volatility goes up by 1 point, your option will increase by .08. If your option volatility goes down by say 10 points, your option price will go down by .80!
The above scenario is very common around earnings season and 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, once the earnings announcement is release, the implied volatility returns to normal which in turn has an immediate negative impact on the option premium.
Consider the recent earnings on NFLX. As soon as earnings were released, the IV dropped by 30 points. Considering NFLX has a vega of .47, a 30-point drop in implied volatility represents an immediate $14.10 decrease in the option premium.
For most stocks the impact of this move does not represent $14.00; however, it can be a sizeable percentage of an option premium. Many option traders have fallen victim to the assumption of a great 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 leads the market makers to widen out 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, often 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 is trading 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 your 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.
It is easy to look at the account balance and assume it is reflecting all of the current information. However, if something looks odd or strange, dig a little bit to see if maybe the last reported price is different than the current Bid/Ask quotes. If it is, then there’s a good chance, it is a component of why your trade price looks wrong.
If you want to understand option pricing more, consider watching our Options Essentials training.
Expand your flexibility and create additional opportunities.