Have you ever bought an option, watched the trade go in your direction (up for a call option, down for a put option) and noticed that your option actually went down in price? How could this be?
A few weeks ago two of our students, Jim and Kara, visited our office from way up in Minnesota. Josh and I both happened to have time so we all went to lunch together. During our lunch Kara told me about an interesting situation that she did not understand. She had purchased a call option, the stock had moved about $8-10 in the direction of her trade, but “for some reason my account is down”.
I knew immediately what her problem could be.
There are only a handful of situations that could account for this scenario.
Scenario #1 - Time decay
Every option trader “knows” that options run out of time and eventually expire. Unfortunately not every new option trader really knows what this means. Let me put it simply - it means that every day your option premium is going to lose money.
Now it should be noted that only the premium portion of the option is subject to time decay. Intrinsic value is not affected by time decay. It should also be noted that time decays faster the closer you get to expiration.
With these two known factors we can set the trade more in our favor by simply following two rules: 1) buy 1-2 strike prices IN the money and 2) buy 4 weeks more time than we expect to need in the option.
By putting these two boundaries on our trades we remove a good portion of that exposure to time decay. However a lot of traders ignore these boundaries because they take a little more capital.
What often happens is a trader will buy 1-2 strike prices OUT of the money, and hope the trade goes up. But what they find is even though the trade moves, it may not move as fast as time decay. This makes it much more difficult to profit on the option and it creates a scenario where the stock can move in the right direction and the option will still lose value.
In Kara’s situation time decay was not the problem. She still had several weeks left in her option and she was already deep in the money. I went to the next most likely cause.
Scenario #2 - Reduction in Implied Volatility
There is a hidden threat to options that shows up in the form of implied volatility. It is particularly rough during earnings season. If you look at the greeks of your option you will see a couple of interesting values. One is the “IV” or Implied Volatility. 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.
So 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! (.08 x10).
This scenario is very common around earnings season. Here’s what happens. 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.
Much to the surprise of many option traders, once the earnings announcement is release, the implied volatility returns to normal. This 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 (0.47 vega x 30 points in IV)!
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.
So I asked Kara if her trade had just gone through earnings and she said no. That left one more logical solution.
Scenario #3 - Wide Bid/Ask spread
When an option moves deep in the money it becomes less attractive to speculators. As a result, there is less volume on the option. This leads the market makers to widen out the Bid/Ask spread. And before you know it, your account balance looks like your option is losing money when in fact it is not. How?
Account balances are based on the “last price” that an instrument actually trades. However, with options that are deep in the money, often times 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. But here 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.
So imagine you own a few contracts of the $170 put option. You have over $15 of intrinsic value. But the last price is actually less than the current intrinsic value! This will mess up your account balance and lead you to believe that your account is going the wrong way when in fact you were correct in the trade and in fact 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.
“Ah-ha!” That was Kara’s problem. She was deep in the money. The last price on her option was showing almost $2.00 below the current bid/ask and as a result it was appearing as though her trade was not going up. In reality she had a great trade and simply needed to enter a limit order to sell, or in a worst case exercise the option and turn around and liquidate the stock position.
What Kara experienced is a very common among new option traders. It is easy to just look at the account balance and assume that it is reflecting all of the current information. However if something looks goofy, 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 that is a component of why your trade price looks wrong.
If you want to understand option pricing more, consider watching our Options Essentials training
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