So you’ve bought an XYZ March 50 Call for $2. The stock goes up to $52, which means your call is at-the-money and your investment has yet to become profitable for you.
On the other hand, your out-of-the-money ABC June 30 Call, with the stock at $28, is absolutely on fire.
The stocks are trading relatively close to the strike price of your options, yet the one that “should” be profitable isn’t and the one that “shouldn’t” be, well, is. You might be wondering what kind of parallel universe your trading portfolio is in.
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To understand why an option’s price is what it is, turn to your fraternity buddies — literally.
Delta: This ratio might give the greatest indication of the ratio of change between the underlying asset’s price in relation to the change in the option’s price. An option’s delta aims to approximate how much an option will change in price for every $1 move in the underlying stock. The deeper in-the-money the option, the higher the delta and, thus, it’s more likely that the option moves in tandem with the stock. (That is, if the stock jumps $1, the option could also go up $1.)
Theta: You may know theta as “time decay.” The further away an option is from its expiration date, the more time value (also known as extrinsic value) the option has. The more time a trade has to work out before the options expiration date, the more valuable it is, time-wise.
Vega: When you think of “vega,” think about “volatility.” When an option’s price swings, and yet the underlying instrument remains fairly steady, it’s because market volatility or the company/index/fund itself has spiked. Particularly apparent in options that are closer to expiration, a rise in volatility could cause the value of the option to fall, and the ratio of price change to volatility change amounts to an option’s vega.
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There are a variety of others joining the party — beta, gamma, lambda and rho — but the ones we’ve discussed today are likely to be concepts you’re aware of but might not have realized how they affect your option’s price.
Understanding that these fraternity brothers are at work behind-the-scenes will help you to recognize why there are some days when your portfolio looks pristine and, other days, it might look like a scene out of “Animal House.”
For more information on delta and what it means to your options trades, check out Ken Trester’s “4 Factors in Play with Options Trades.”
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