Why does the call option's value decline even if the stock price rises? So, let us understand how and why this happens. Many factors influence options pricing, which are very important for you to understand.
If you want to avoid this type of situation while dealing with the options, you must know why the value of the option declines even if the stock price rises.
The calculation of option pricing is quite complex and may confuse you, especially when you are unaware of the guidelines. It must sound confusing, but the stock's price is just one factor that impacts the value of the option. Thus, here on this page, we shall see some of the guidelines you must adhere to understand why option contracts value decline, even with the rise in the stock price.
The common scenario:
You are looking at your position in the options contract, and something is going wrong there; you don't understand what? Suppose the stock price is increasing, and you thought it would rise even higher; based on your prediction, you bought the call options. Still, you are losing money; why so?
Many of you might have seen this type of situation often. In reality, thousands of traders face this every week or month, which is the main reason you must understand option pricing and its importance for your trade to succeed.
Understand the difference between the stock price and Strike price:
While determining the value of the option contract, a factor that plays a major role is moneyness. You might not know what moneyness is, but you must have heard the types of moneyness; in-the-money, at-the-money and out-of-the-money. The term moneyness refers to how the option's strike price is related to the current trading price of the mentioned asset. It can also be said as the current intrinsic value of an option.
The pricing of the option is based on two main components: Its intrinsic value and extrinsic value.
Intrinsic value is the remaining value of an option if it expires at the moment.
Extrinsic value does not have a major role but comprises several components, such as time value or theta. As we say, time is money; in options trading, time is value.
Now, let us understand how the strike price and stock price relate to each other. So, the strike price is a price that a buyer of the call option pays to buy the shares on or before the expiry of the contract. Here comes the part of moneyness; it decides the profit and loss; check below:
When the price of the stock exceeds the strike price, it is known as an in-the-money call option.
When the strike price surpasses the stock price of the underlying asset, it is known as an out-of-the-money call option.
When the strike price equals the stock price, we call it at-the-money (ATM) call options.
You incur a loss when the stock price is not above the strike price.
The decrease in time value:
The time value, theta, and theta burns are all the same terms; they are the most dangerous factor affecting the option's value. The more time the option has in expiring, the more changes it can undergo, but the lesser time does not allow the movement, and thus the value of the options contract declines with each passing day. The traders who deal in the stock don't have to worry about the expiry, as stock does not have an expiry period, but the options do! Thus, in order to earn a profit in option trading, the stock price must exceed the strike price before the option expires or theta eats its value.
Decrease in the market volatility:
The out-of-the-money options are generally based on the time value, volatility and premium paid. Volatility can be explained as fluctuations in the stock price. The higher the volatility, the higher fluctuations and the higher chances of the price reaching near the strike price. The options having higher implied volatility have more value. If the implied volatility decreases, the option contract loses its value even though the stock price rises.
Dividends on the underlying asset:
When you have dividend-paying stock, traders would be more likely to hold the stock rather than to be involved in the options contract. This is because traders do not get dividends if they do not own the stock. Thus, stocks with high dividends do not have a good option price.
Rate of interest:
With the rise in the interest rate in the market, the premium on the call options also rises, creating a negative impact on the option contract. Who would have thought that the interest rate could also affect the options pricing? But that's true. It's one of the Options Greek known as Rho.
So, we hope you must be clear on the factors due to which the value of the options contracts declines even though the share prices are rallying. So, next time when you are trading options, kindly keep all these factors in mind and then decide your next move.
Again, if you have any questions or doubts, feel free to contact us at the given number or email.