Manage episode 238079396 series 1615906
Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to be answering a common question we get which is – “The stock moved the right way, but my option lost money?” And so, this is a common question that people get, especially people who are starting out trading. Even some experienced options traders I think fall quickly into this little pitfall of not understanding really what’s happening with the position or just maybe losing sight of what’s happening with the position. But let’s say you get into a position and you’re anticipating that the stock is going to make a big move higher and you get that big move higher, but your option contracts lose value. And this can be frustrating, I get it, because you’re positioned for that move, you’re expecting that move and then you actually predict or assume that the stock is going to go higher and you do it correctly, but you get a loss in value for your option contract. This can be tough because it’s probably one of two potential things that happened. One, either the stock didn’t move far enough for you to actually realize a profit yet. This is probably the first likely scenario that even though the stock moved in the right direction, you actually needed a much bigger move to realize a profit. Now, many people would know this from looking at their option payoff diagram, that they need to get to X breakeven point, but sometimes this is not as intuitive as you might think. Some people might buy option contracts assuming that just a simple move higher will create a profit when the case is actually, they need a $5 or a $6 move higher to get beyond their breakeven points. The first answer to this is the stock may had not have moved far enough to get to your profit window.
The second and more likely answer to what’s happening is a change in implied volatility and this can affect both option buyers and option sellers. Usually, when we have a stock move the right way, but we lose option, we lose value in our option contracts. It’s because of a change in implied volatility for that option contract or the market in general. As an option seller, we might see a stock move right into our profit window, but we might be losing money in that process because now, market implied volatility is much higher. It’s gone from a low level of volatility to a high level. Even though pricewise, the stock is right where we want it to be, because overall volatility has now caused option premium to swell, our position looks like it’s going to be or has a paper loss at the moment until we see a lot of that volatility come back out of the contract. The same thing can happen in reverse to option buyers. Many option buyers are anticipating a very large move in the underlying stock. And so, you might get that large move in the underlying stock, but at the same time, implied volatility or the expectation of volatility is now sucked out of the contract and that impacts the contract much more so than the large move that you got. Even though you might have predicted the right move or you might have predicted a large move, it’s that implied volatility getting sucked out of the contract that actually causes you to lose money. Now, this is important because again, option contracts are multidimensional. This is a hard concept I think for a lot of people to understand. It’s not as intuitive as stock trading. Stock trading is super, super simple. The stock goes up and you have long stock, you make money. The stock goes down and you got short stock, you make money. But in option contracts, you have this multidimensional facet. You have not only the directional move of where the stock is going, but how implied volatility and how time decay are impacting that position as well. And so, again, even though a stock can move the right way, you could lose money because of just the magnitude of move, the passage of time and/or implied volatility changing in the market.
Hopefully this helps out. As always, if you have any questions or any specific examples you want me to go through, let me know. Add a comment in the comment section right below this video wherever you’re watching it and again, share this online. Help spread the word about what we’re trying to do here at Option Alpha and until next time, happy trading.