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Understand How Option Premium Moves
08/16/2011 7:00 am EST
This real market example shows how the option premium of an in-the money long call changes as the underlying equity’s price fluctuates throughout the life of the option.
The aim of this MoneyShow.com article is to explain how the option premium of an in-the-money (ITM) long call changes as the underlying moves on the price chart. There will be three points in time that we will examine.
We will use the Diamonds Trust (DIA), which tracks the Dow Jones Industrial Average, for our example. At the first point in time that we will use, the fund was trading at $126.50 and a one-step, in-the-money long August call was selected.
Part One: Friday Close (July 8, 2011)
On July 8, after the Dow (and DIA) had been in a strong uptrend for a number of days, it became evident where the next area of resistance would be—at the $127 level. Figure 1 shows the daily chart of DIA creating (at that time) a formation that seems like a bull flag.
The flag pole of the Bull Flag had formed since the June 27 rally initiated. After seven days of a strong upward move with only one day of pause (the small doji), DIA ran into the supply zone around $127 and pulled back.
The question then became how much would DIA retrace before making an attempt for another leg higher? On that Friday close, DIA was at $126.50, and the call premium for the August 125 call, which had an intrinsic value of $1.50, was $3.00. From this moment on, we will observe what took place with the August 125 call as DIA moved up and down.
PART Two: Tuesday Close (July 19, 2011)
Figure 2 shows the DIA retracement being completed on July 18 at the 50th percentile. For those unsure of the measurement reasoning, let me explain that I have attached Fibonacci levels to the lowest point, which was created on June 25, to the highest point, made on July 7. The 50% Fibonacci was right in the middle around the $123 zone.
See related: Fibonacci Analysis: Master the Basics
To be exact, Figure 2 shows the reading for the 50% Fib level at $122.91, and since that level, DIA has again lifted. At those levels, the August 125 call would have lost all its intrinsic value and the entire premium would only be composed of “fluff,” or extrinsic value.
The premium at those low levels was around $1.50, which was the time value, or extrinsic value. At the original entry price of $3.00, half the premium was true (intrinsic) value while the other half was fluff.
NEXT: See Price Action with Underlying Testing Key Supply Level|pagebreak|
Part Three: Tuesday Close (July 26, 2011)
Figure 3 shows DIA hitting the same supply zone at $127 on two occasions, failing to break through it both times.
However, what is interesting, technically speaking, is that DIA is stuck in an ascending triangle pattern. Figure 3 also shows the diagonal trend line, which has four touches, the fourth one being formed on July 26. With DIA sitting at $124.83, the long August 125 call once again lost its intrinsic value and is completely composed of fluff.
Figure 4 below shows the daily price chart of the August 125 call premium with vertical lines indicating the three dates analyzed in this article.
Notice how the premium value has decreased and increased proportionately depending on what DIA was doing at the time.
This last figure below shows the two charts side by side. The one on the left is of DIA, and close examination shows the gray zone of support at $127 being touched twice. The right chart is the same as Figure 4, the chart of the actual August 125 call premium, so that we can compare its gray zone with the DIA gray zone. Do you notice anything different?
Hopefully, you were able to observe that the August 125 calls never created exactly the same high as DIA did. There were not two exact touches.
There could be a couple of reasons for this. There is the possibility that the discrepancy is due to Theta (time decay). The other reason is that the August 125 might have been quoted at the $3.50 level, but no trades actually executed at that exact price.
See related: Option Traders, Don’t Trust Theta!
In conclusion, this article pointed out how a long call is positively correlated with the underlying stock. When DIA went up, the long ITM call increased in value. By the same means, the opposite was true: While DIA was in a downtrend, the long ITM call first became ATM and then even OTM as DIA traveled lower. In the days DIA rallied, so did the long call, gaining back its intrinsic value.
In short, when trading options, keep your eyes on the intrinsic value at all times.
By Josip Causic, instructor, Online Trading Academy
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