Options 101: Determinants of Call Option Prices
Call buying is a basic 101 options strategy that, on the surface, is easy to understand. Most people recognize that, if you buy a call option, you want the underlying instrument to move up! The amount a call option will increase in value for every point move in the underlying is measured by delta. If the delta of call is .50, it can be expected to increase in value by .50 if the underlying move up 1 point. However, other factors – like changes in implied volatility and time – will also affect an options position. In fact, it is possible that the call option loses value even if the underlying moves higher. Let’s see why using a realworld example from recent options order flow.
One week ago, we detected a large buyer of July 40 call options on the iShares Emerging Markets Fund (EEM). Less than an hour before the closing bell last Friday, with shares around $37.90, the investor bought 44,000 July 40 calls on the exchange-traded fund for 51 cents per contract on the AMEX. A source on the floor confirms that calls were bought and open interest numbers Monday indicate that a new position was opened.
July 40 calls on EEM were 5.5 percent out-of-the-money at the time. The delta was about .25 and therefore if EEM jumped a point, the calls might be expected to increase by about .25 or 50 percent. That’s the power of leverage. Small percentage moves in the underlying translate into large percentage gains for the options contract. The breakeven of a July 40 call for 51 cents at expiration is $40.51 and equal to the strike price plus the debit paid. The premium is at risk if shares hold below $40 and the position is left open through the expiration (5 weeks). However, the position can be closed out at any time prior to the expiration. The payoff chart shows the risks-rewards of an EEM July 40 call.
Fast forward to today and it appears that the position is being closed, as 43,000 July 40 calls were sold for 54 cents per contract on AMEX. Shares are up to $38.80, or about 2 percent, on the week but the gain on the calls is only three cents. On 43,000 contracts that’s not exactly chicken feed (unless your chickens like to eat $129K in options profits) but certainly not the gain that might be expected after the underlying moves up 90 cents. What happened?
One, slippage was a factor. The investor paid 51 cents when the market was 50 to 51 cent last week and sold at 54 cents when the market was 53 to 55 cents. Second, time decay hurt the trade. The theta of the contract, which measures the amount of premium lost per day, is .01 – therefore 5 cents of premium was lost due to the passage of time alone. Finally, implied volatility in the contract eased from 27 to 26. Vega measures the amount of premium that an options contract can gain or lose for every point change in the underlying. The vega of the Jul 40 call is about .05. So, the contract lost about a nickel due to the 1-point drop in IV.
Therefore, although the massive block of July 40 calls benefited from an increase in the underlying (delta), it was hurt by falling volatility (vega) and time (theta). The position was probably being closed out today to bank the profit rather than running the risk of holding calls on the emerging markets heading into pivotal Greek elections Sunday. See you Monday!
Category: All ETFs, Trading Education
Free Newsletter
If you enjoyed this article, sign up to receive more just like it.
About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.
