Tag Archives | option prices

the Magic of Higher Call Prices for Falling Stocks

Mark,

I still consider myself a rookie so I have what may be a
"rookie" type question.


I am selling covered calls and I am seeing that
the option/stock price relationship has NOT been maintained in a way
that I would expect. The AAPL stock price is lower, but the option price is still higher than when I sold it. (There
was a big run up in price before falling back to today's level.) There
hasn't been much passage in time as I bought/sold in April.

What would cause this? (I have to admit I don't understand the Greeks
yet.)

Thanks

Larry

***

Hi Larry,

This is a common problem and easily explained.  Once you get it, you will remember.  But, until you read or hear that explanation it can be a true puzzle.

An option's price is based on several factors, such as the stock price, strike price, time remaining.  But the crucial factor that determines how much the price of an option changes in the marketplace is volatility.  Each of these factors is plugged into a computer, which calculates the value of an option based on one of several models.  One of those models may be familiar to you: Black-Scholes.

Simply stated, if market participants believe the market (or sometimes the specific stock) is going to be volatile from right this minute through expiration day, then the options are worth more.  Buyers bid higher prices and sellers demand a higher premium for the risk they are accepting.

Why do they bid more?  If you buy an option, you want to see the stock move higher (calls) or lower (puts).  The larger the anticipated move, the greater the profit potential.  That translates into higher bids for those options.  Similarly for sellers, big moves turn into larger losses, so they demand higher prices to offset some or all of that risk.

That expectation for increased volatility (compared with the expectation when you wrote or sold that call) is the reason the option prices is higher.  And that option price can go higher still.  Or it can drop like a rock.  All depending on that expected volatility.

To keep it simple, a volatility estimate must be plugged into the Black-Scholes model to generate a theoretical value for the option.  the higher the volatility, he higher the option price.  If you have never played with an option calculator, you should do so.  It can open your eyes.

But that's the reason your call is priced higher today, even though the stock is lower and some time has passed.

Regarding the Greeks.  Do not be afraid of them.  the Greeks serve one purpose:  To measure risk of holding a specific position.  When the investor finds that risk to be unacceptable, action is taken.  You may exit or adjust the trade.  The point is that the Greeks give you a good estimate of how much you may make or lose if such and such market event occurs. 

682



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