Why Does the Call Decrease When the Stock Increases?

11/26/2009 12:02 am EST

Focus: OPTIONS

Chris Johnson

Editor, The Winning Edge

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.

Time value is the main difference between stocks and options. Stockholders 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 above 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!

By Chris Johnson of The Winning Edge trading service

Chris Johnson is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events.

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