#58 - Why Didn't My Option Move As Much As The Underlying Stock?
Hey everyone, Kirk here again and welcome back to the daily call. On today’s call, I want to answer the question – “Why did my option move as much as the underlying stock?” This is a popular question actually. In fact, I think it’s one that’s just very common if you're new to trading options. But honestly, if you’ve been trading options for a while, you still might question this and here’s where this really comes from or here's the setup that this comes from. Let’s say that you are long a call option on the stock at $50 and your strike price is at $50. Naturally, most people think that because your strike price on your long call option is at $50 and the stock is at $50 that any move higher in the stock is going to see an exponential or at least a 1:1 move higher in the option contract that you’re long. The next day happens and the stock moves $2 higher. The stock moved $2 higher, but now your call option drop in value. This is where people go crazy. They literally start pulling out their hair, they have no idea what’s going on and there could be a couple of things that have caused this. Really, there’s mainly two things that might have caused this. One is implied volatility. That’s the biggest factor. We know that that's the biggest factor because that’s where we get our edge in option pricing. It’s that this implied volatility, this future expectation that’s baked into these option contracts has everything to do with how much they change in value from a given day or given month or week. What could've happened with your contract is that even though the stock moved $2 higher which was a big move for a $50 stock, that could've been after an earnings event. After earnings, implied volatility drops dramatically. Sometimes we’ve seen 50, 60 points move down in volatility. Even though the stock went higher, the implied volatility just got sucked out of the contract and now, even though you made money on the move higher, the Delta move higher in your long contract, you lost even more money on implied volatility decaying or basically evaporating in the contract. That's why we say that you want to be a seller of implied volatility because that edge is always greatest. It’s very, very hard to consistently buy options and get it right and still pay the implied volatility premium that’s in the market. That’d be like trying to buy insurance on a house knowing that a hurricane was going to consistently hit the same area over and over and over again or knowing that the house was going to burn down over and over and over again. That’s what you’re trying to do with option contracts. You’re trying to buy insurance hoping that something is going to go crazy and you’re going to make a lot of money. It doesn’t really work out that way. You could get lucky for sure, but it’s not a consistent way to run a business. That’s the first thing. You could see implied volatility drop which is why your option contract didn't move as much as the underlying stock. The second thing that could’ve happened (this usually happens more over the course of a couple of days, but could still happen for sure) is you get time decay that’s starting to road out of the contract. The way that I visually think about time decay is I think about time decay as a slow drip from a bucket of water. The bucket and the water are your option contract with all the value that's built in there. At the bottom of every bucket is a hole and that is time decay. Time decay slowly erodes the value. The water starts slowly dripping out of the bucket and it starts eroding the value of that contract. No matter what happens, no matter where the bucket goes, no matter where the stock goes, that is always there, it’s always present and moreover, it's increasing. It has an exponential feature that it starts to speed up as we get closer and closer to expiration. What people often have trouble with in trading options when they get started is just realizing these extra dimensional features of pricing. It’s not linear anymore. It’s not like a stock where if the stock goes up by $1, you make $1. Now, you have to price in these ulterior pricing dimensions really, like these alternate dimensions of volatility and time decay and how that impacts the options price. Really, it's very simple to understand. We’ve explained it here and we’ve got other training on the website that helps. But hopefully that gives you a basis for how that might happen. Again, we get this question a lot, so hopefully that helps you answer the question. It could be two things mainly, volatility and time decay. Make sure you check those with your contracts and always be selling options. Until next time, happy trading!