Chris Johnson

Why Does My Call Decline When the Stock Gains?

by Chris Johnson   01/28/10

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Time value is the main difference between stocks and options. Stock owners don't have to worry about time value. But option owners do, because time value decays at an increasing rate as an option approaches expiration. Thus, an option owner needs a stock to move in the right direction to counteract the damaging effect of time value.

Time Until Expiration

I mentioned earlier that time decay (or erosion) works against an option owner because time value decreases as expiration approaches. Time decay increases as expiration nears, so time takes on added importance for options with a few weeks or days until expiration. Time decay has a greater impact on ATM and OTM options because their premium consists entirely of time value.

Implied Volatility

Volatility is simply the propensity of the underlying stock to fluctuate in price. Option premiums are proportional to the expected volatility of the underlying stock.

Implied volatility is the market's assumption of the underlying stock's future volatility. That sounds fairly simple, but it isn't. Volumes have been written on implied volatility, so it's best to leave this ingredient alone for now.

Dividend Status

Dividends increase the attractiveness of holding stock rather than buying calls and holding cash (call buyers are not entitled to dividends).

Conversely, short-sellers must pay out dividends, so buying puts becomes relatively more desirable than shorting stock. Therefore, larger dividends reduce call prices and increase put prices.

Interest Rates

Rising interest rates help call premiums and decrease put premiums. Higher rates increase the underlying stock's forward price (the stock price plus the risk-free interest rate). The forward price is assumed to be the value of the stock at option expiration.

Some option players prefer to trade on volatility projections by buying low volatility and selling high volatility. They assume that stock prices are random and do not trend.

However, the price of the underlying stock is of greatest importance, and a strong, quick movement in the right direction is the main ingredient for big profits. Therefore, being able to successfully predict the underlying stock move is the best recipe for success.

All the option strategies ever devised don't amount to a hill of beans if you can't predict what the underlying stock will do.

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