Here at SlingShot Trader, we buy a lot of calls and puts. The calls typically make money when the underlying stocks moves higher, and the puts typically make money when the underlying stocks move lower.
You’ll notice we said “typically.” That’s because the movement of the underlying stock isn’t the only thing that affects option premiums. Time decay and changes in implied volatility also have an impact on option premiums.
You are probably quite familiar with the concept of time decay. Because options have expiration dates, they are considered to be deteriorating assets. That means as time passes, calls and puts lose value. This deterioration is measured by the Greek letter “theta.”
Vega and Implied Volatility
An option trading concept you might not be as familiar with is the concept of “vega.” Vega is the Greek letter used to represent the impact changes in implied-volatility levels will have on an option premium.
Long calls and long puts are both long vega. This means that when implied volatility increases, it has a positive impact on the premium of the options. Conversely, when an option is short vega, it means that when implied volatility decreases, it has a negative impact on the premium of the options.
So what happens when you buy a put and the value of the underlying stock drops while the implied volatility of the option declines at the same time? Depending on the magnitude of the move in the underlying stock, and the magnitude of the decline in implied volatility, the value of the option could move higher, or it could move lower or remain flat.
Take the yesterday’s action on the Radio Shack (RSH) August 3 puts for an example. The value of the underlying stock started to move lower, but because RSH had just released earnings, the implied volatility of the option was also declining. This is normal after an earnings announcement. As you can see in the image below, implied-volatility levels tend to ramp up before an earnings announcement because the uncertainty regarding how the stock is going to react to the earnings announcement escalates.
However, after the earnings announcement, implied-volatility levels tend to drop off dramatically because there is much less uncertainty swirling around the stock.
The Bottom Line
The take-home message is that option premiums react to a variety of different inputs, which is why option trading is much more complicated than stock investing.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.