Chris Johnson

Why Does My Call Decline When the Stock Gains?

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Stocks and options are, of course, very different animals, and a stock's price is but one of several factors that impact the price of an option.

While the question of option pricing is one typically asked by newcomers to options, the answer is not always straightforward. In fact, option pricing can be downright maddening.

You may own a call on a stock that goes up one day, while your call loses value. Honestly, it's not that uncommon. That's why knowing the ingredients of option pricing is so important.

So let's get started. The very simple answer to option pricing is that the premium of an option is determined by supply and demand in the marketplace.

But it's obviously not that simple, as a number of factors combine to determine the theoretical price of that option, which usually is fairly close to the actual market price. So what are these theoretical components of the price?

Relationship Between Stock Price and Strike Price

This is the most important factor and the one that most identify with the option's price. The strike price is the price that a call buyer may purchase the shares or a put seller may sell the shares.

When the stock price is above the strike price, a call is considered in the money (ITM) and a put is out of the money (OTM). The situation is reversed when the strike price exceeds stock price -- a call is out of the money and a put is in the money. An at-the-money option (ATM) is one whose strike price equals (or nearly equals) the stock price.

The amount an option is in the money is called intrinsic value. The difference between an option's market price and the intrinsic value is time value. Because an OTM option has no intrinsic value, its price consists entirely of time value.

Time value is very important, because it erodes such that it disappears completely at option expiration. Thus, an option's worth at expiration is only the amount it is in the money. The more an option is in the money, the higher its value.