My family celebrated the holiday like most of the rest of the country. For us, it was a annual parade in our town and a cookout at friends. Like many across the country, it was the hottest 4th of July I can remember. My phone showed a local reading of 102 at 3pm. This was observed while myself and a group of scouts and dads were taking down our Scout float in a parking lot just off the parade route. Now I don’t like January in the Chicago area with our 10 degrees and below 0 windchills, but for a fleeting moment I caught myself fantasizing about the snow and wind. But just then my son dumped a glass of ice water down my back and I snapped out of it. 102 is tough but for me, I’ll take it over 10 below.
The other day someone was telling me that they had purchased some calls and were excited at first because the stock had rallied. But after looking at their calls they noticed they had barely moved. If you are a fairly experienced options trader, you understand why this can happen. But for those less experienced, this may seem to not make much sense. After all, calls are the right to buy an underlying at a particular price over a defined time period. If the stock or underlying rallies, than the call, or right, should go up too. Correct? The answer is yes and no.
There are two main factors that drive options prices – price movement in the underlying asset and also implied volatility. In the case of the calls, the underlying moved up, which depending on delta and gamma of the call, should cause the call to increase in value. If the underlying goes up by $1 and the delta of the call is 30, than the call should in theory increase by roughly $.30. However, the other factor, implied volatility, can change during this time which can also affect the price of the option. So in our call example, while we might expect the call to increase in value by $.30, if implied volatility goes down as the market in the underlying rallies, the price of the option may only increase $.20 depending on how much implied volatility falls.
In effect, even though markets are moving up, the overall demand for these calls may be going down effectively dampening the expected price increase. The other thing to consider is as volatility goes down, the expected movement is lower, meaning that it is less likely that out of the money options will finish in the money. This will tend to push out of the money option deltas toward zero faster than if volatility did not decrease. Keep these factors in mind especially when using calls as adjustments for existing positions.