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Why Would Call Option Value Decline If Stock Price Rises? Evaluating Option Greeks

Covered call writers and put-sellers know that option value is impacted by the change in stock price by the amount of its Delta. Delta, one of the option Greeks, is defined as the amount an option value will change for every $1.00 change in share value. If a call option priced at $2.00 with a Delta of .50 sees its underlying security rise in value by $1.00, the theoretical value of the option will rise to $2.50, all other factors remaining the same. However, there are times when stock price moves up and option value moves down (and vice-versa) and to explain this we need to explore other factors that influence option pricing.

 

Other Greeks

Let’s look at the other four Greeks and see which is the most likely to result in this unusual inverse relationship between share price and option value for calls:

Gamma

Gamma is a second generation Delta. It’s always positive and will only result in option value increase as stock price rises…can’t blame Gamma.

Theta

Time value erosion is logarithmic in nature (not linear) especially for near-the-money strikes and can certainly negatively impact option value over time. However, what if option value goes down the same day share value rises. When this occurs, we can’t blame Theta.

Rho

Interest rates have very little impact on option value especially in low-interest rate environments. When rates are changed, it is usually by 25 basis points and so Rho is considered a secondary Greek, with little influence on our 1-month option-selling decisions. Definitely, can’t blame Rho

Vega

By process of elimination, this apparent anomaly must be caused by Vega, the amount an option value will change for every 1% change in implied volatility. A decrease in implied volatility can counterbalance an increase due to Delta as share price rises.

 

Real-life example

One obvious time of decreasing implied volatility would be before (higher volatility) and after (lower volatility) an earnings report. Nike (NKE) reported earnings after hours on 12/22/2015. Here is the chart for the $130.00 in-the-money call option just prior to market close that day:

Option Greeks

NKE $130.00 Call Option before Earnings

Note the following:

  • NKE trading at $131.85 (yellow field)
  • $130.00 call trading at $5.50 (brown field)
  • Delta = .58 (red oval)
  • Implied volatility = 33.54% (green oval)

The earnings announcement was initially received positively and here is the screenshot of that same option the next day:

Covered call writing and option Greeks

NKE $130.00 Call After earnings

 

Here we see stock price moved up approximately $1.00 to $132.79 (yellow field) but option value declined to $5.00 (brown field). Factoring in Delta alone, we would expect option value to rise by the previous delta of .58 resulting in a new option value of $6.08 ($5.50 + .58). However, note that the implied volatility (green oval) has declined substantially to 24.43% after the report was made public. Although the Delta component was pushing option value higher, the Vega component not only neutralized Delta but actually caused the option value to deteriorate. As an aside, note that Delta moved up to .65 as the $130.00 strike moved deeper in-the-money.

 

Discussion

The Greeks are a mathematical means of calculating the risk inherent in our option positions. Each of the five Greeks are defined based on all others factors remaining constant. In the real world, all other factors are dynamic and so to understand option pricing we must integrate all the Greek factors into the equation. Our goal, as Blue collar Investors, is to become educated to the highest possible levels so our returns can also achieve those heights.

 

Blue Collar Scholar Competition: 

Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)

Michael M

Roni S

Michael P

Sample Commentary from Michael M:

“Unfounded reaction to Fed decision on interest rate, the “lack” of investing by millennials, a weak energy sector and a still strong dollar will be major contributing factors causing the S&P sliding sideways to December 2015”.

The six winners will be published in the January 10, 2016 newsletter.

 

Upcoming live appearances

1- Saturday January 23rd, 2016: Kansas City, Missouri

9 AM – 12:30 PM

Matt Ross Community Center

 

2- New York Stock Traders Expo

February 21st – 23rd

Marriott Marquis Hotel, NYC

http://www.newyorktradersexpo.com/expert-details.asp?speakerID=891071A

 

Events calendar

 

Market tone

This shortened week’s news had a mixed tone to it. This week’s reports:

  • The manufacturing sector has had a number of indicators come in softer than expected in recent weeks as the ISM is in contraction territory
  • Durable goods orders were unchanged in November, better than the
  • 0.6 percent decline that the consensus had expected
  • The volatile transportation sector increased 0.4 percent
  • Excluding transportation, durable goods orders slipped 0.1 percent, the third decline in the past four months
  • Personal income increased 0.3 percent in November, which matched the 0.3 percent gain in inflation-adjusted consumer spending. Steady labor market gains have supported growth in personal income in recent months
  • Consumer spending grew at a 3.0 percent annualized rate in the third quarter and was the largest positive contributor to the overall GDP growth rate for the period
  • Existing home sales declined by 10.5 percent in November. The primary reason for the soft turnout in November could have been the implementation of a new mortgage disclosure rule, the “Know Before You Owe TILA-RESPA Integrated Disclosure,” that went into effect in October
  • On the upside, it appears that the impact was temporary as mortgage applications through the second week of December have risen to the fastest seasonally adjusted rate since 2010
  • The latest estimate for third-quarter GDP shows an annualized growth rate of 2.0 percent, down from 2.1 percent previously
  • Consumer confidence fell unexpectedly in November, with the index falling 8.7 points and reaching its lowest level since September 2014
  • Nonfarm payrolls in November posted a second consecutive strong reading, allaying some fears regarding the labor market
  • Despite a decline in November, the ISM non-manufacturing survey remains firmly in expansion territory.
  • Strong nonfarm payrolls gains in October and November helped allay concerns regarding the labor market following the slowdown in employment growth earlier this year. This gave the Federal Open Market Committee (FOMC) the confidence it needed to proceed with increasing the fed funds rate for the first time in almost a decade

For the week, the S&P 500 increased by 2.76% for a year to date return of + 0.10%.

Summary

IBD: Uptrend under pressure

GMI: 1/6- Sell signal since market close of December 10, 2015

BCI: Cautiously bullish but remaining in a defensive posture selling at least 50% in-the-money strikes and deeper out-of-the-money puts until there is clarity regarding the market reaction to the Fed rate hike.

The BCI team wishes you a happy and healthy holiday season and a lucrative 2016,

Alan (alan@thebluecollarinvestor.com) and the BCI team

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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17 Responses to “Why Would Call Option Value Decline If Stock Price Rises? Evaluating Option Greeks”

  1. Barry B December 26, 2015 10:00 pm #

    Premium Members:

    This week’s Weekly Stock Screen and Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 12/25/15.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and the BCI Team

  2. Brandon December 27, 2015 1:03 pm #

    Alan,

    I would like to thank you for the time and effort you have placed in your books and guides. I have a question for you as a new investor. I have a cash account of ($ 1,500.00) to use/invest in the market. I have purchased your covered call encyclopedia and began reading it. One of the first things I have realized is my low capital that can be used to buy the 100 shares of stock for the first leg. My question to you is, since I have such a small account size, should I hold off on using this strategy until I can build it up more? Or do you recommend another strategy for a small account? I appreciate any direction you may offer! I look forward to hearing back from you.

    Thanks,
    Brandon

    • Alan Ellman December 28, 2015 6:48 am #

      Brandon,

      You have tremendous opportunities on both fronts…you can grow your portfolio value while learning how to sell stock options. The process is not mutually exclusive. Start the learning process today.

      Now, to grow your portfolio value check out my book, “Stock Investing for Students”

      https://www.thebluecollarinvestor.com/stock-investing-for-students/

      It will show you how to enhance your portfolio net worth until you are funded for option-selling (As a guideline, at least $10 – $15k to start with exchange-traded funds). The process described in this book is extremely user-friendly, almost automated so while actively investing from this perspective you can be studying and paper-trading the information in the “Encyclopedia…” By the time you have enough cash for option-selling you will have mastered all three aspects of option-selling.

      Education is the key to achieving financial independence and becoming CEO of our own money.

      Alan

  3. David December 27, 2015 1:15 pm #

    Alan,

    I read your book selling cash secured puts and I have several questions.When your stock experiences a significant decrease in value a GAP DOWN and after review I deem the reason for the gap down not to be very serious.I understand we hold the stock but what I’m uncertain about is whether I still hold the stock thru an earnings report?On page 141 of the book you indicate earnings reports are avoided(no call options are sold prior to earnings report)and call options are sold after the report passes.You further indicate the process of writhing OTM covered calls continues as long as the security meets the system criteria outside the gap down.This advice “implies”that I hold the stock thru an earnings report ,am I correct in this assumption?If I am correct and I do hold the stock and sell OTM calls why would you require the system criteria( 2% ROO) to to be meet outside(below)the gap down price? I am ASSUMING I sell OTM calls in an effort to facilitate the recouping of my unrealized losses? If so why not sell OTM at 1% and thus roll out or out and up at expiration? Am I correct in in my reasoning for holding the stock thru an E.R. is in an effort to recoup the unrealized loss ? A 2nd question IF I AM CORRECT in my reasoning for holding a stock thru a E.R. would the same reasoning not apply if I initially entered a COVERED CALL trade and suffered a GAP DOWN? Is this gap down scenario the EXCEPTION to the rule of never holding a stock thru an earning report? Thank you for your time and attention to my questions.

    Sincerely David.

    • Alan Ellman December 28, 2015 7:05 am #

      David,

      The gap-down guideline applies to those who own shares in a stock we want to retain despite the gap-down. An example, would be a stock in a long-term buy-and-hold portfolio which has a low cost basis and we don’t want to experience a potential tax consequence. It simply may be a company we have a lot of confidence in and feel that gap-down was not justified. If we decide that we want to retain such a security, it is to our benefit to avoid earnings reports which caps upside if the report is favorable but does not cap downside if report disappoints. If the stock has Weeklys, we can write Weeklys up to the week of the report and then again after the report. If not, wait for the report to pass and then write Monthlys.

      2% is a guideline. It can be altered depending on investor goals and personal risk-tolerance. My personal goals for initial, 1-month time value returns are 2% – 4%. Others may have different goals…feel free to change.

      This strategy is NOT to recoup losses. It is used in a specific scenario where the investor specifically wants to retain the stock based on hypotheticals I alluded to in the beginning of this response. If we have changed our opinion concerning the outlook for a security, it’s time to move on. It’s the cash, not the stock, we care about.

      Alan

  4. Bob December 27, 2015 6:45 pm #

    Hi Alan:

    Your book says to sell a stock if it decreases “dramatically”. What does that mean; 5%, 10% or what? One Covered Call website I previously subscribed (BCI is much better) had a rule to get out of a trade if the stock’s net decrease was 10%. That meant a 10% decrease after losing the option premium or a total much greater that 10%.

    Bob

    • Alan Ellman December 28, 2015 7:23 am #

      Bob,

      Since we are in 2 positions (long stock, short option) we must deal with the short option first to avoid finding ourselves in a risky naked option position. For most retail investors, our brokerage will not permit closing the long stock position without first closing the short option. A higher level of trading approval would be required.

      Assuming we must deal with the option first, our guideline is for premium to decline to 20%/10% of initial option sale depending on where in the contract period we are. Once closed, we now own the shares without obligation and can proceed in several ways (wait to re-sell option, roll down, sell the stock). Now to your question…Favor closing the entire position when chart technicals are breaking down and the stock is under-performing the overall market. No one knows for sure if a stock will rebound but chart technicals are extremely helpful in throwing the odds in our favor as is overall market assessment and checking the news for the company in question. That’s how I do it. If I were forced to give a percentage guideline on the stock side after closing the short option I would look to an 8-10% decline in share price as discussed in my book, Stock Investing for Students” which details investing without options.

      To sum up: I use chart technicals, checking company news and overall market assessment to determine when to sell a stock in my portfolio after closing the short option.

      Alan

  5. Jay December 28, 2015 1:18 pm #

    Friends,

    It is great to read Roni and the Michael’s are leading the contest! I got ahead of myself and thought the S&P might be up around 2200 by Thursday close…..oops!

    Mike M., what an insightful yet troubling observation: the Millenials are not investing. I can’t say I invested much at their age either. But I funded my IRA and my 401K. The rest went to living at the edge of my means. Maybe I was a Millenial before my time :)?

    I have yet to read an overly rosy prediction for 2016. Normally the bulls run wild this time of year. Maybe that is a good thing. Investor sentiment is sighted as a contrary indicator. If most are fearful a crash is unlikely. More likely the opposite.

    But a quiet melt down as more folks and institutions lose faith and hoard cash is within the realm of possibility. The more I think about it the more I grow convinced 2016 will be the “Year of the Covered Call Writer”. No need to sell our stocks. Just rent them! – Jay

    • Roni December 28, 2015 3:10 pm #

      Thank you Jay, but I really wish I am wrong and you are right by the end of the week.

      Cheers – Roni

  6. JJ December 28, 2015 9:52 pm #

    This sort of phenomenon is fairly rare but still possible, usually when an option that started with an unusually large amount of premium (due to a high implied volatility) approaches expiration.

  7. Paul December 29, 2015 7:55 am #

    Alan,

    Does your premium report offer lower
    priced stocks in the $5-$20 range? I’m
    under the impression that the premiums
    are generally similar for near-term options
    whether the security is $15 or $50, and
    with the lower prices, you can get more
    shares.

    Thanks,

    Paul

    • Alan Ellman December 29, 2015 9:25 am #

      Paul,

      There are some stocks in our stock and ETF reports priced under $20 but not many. Higher quality stocks are generally priced higher and we demand elite-performers in our reports.

      Outside of the requirement to buy stock in 100-share increments, there is no advantage to owning more shares as long as we are appropriately diversified. It’s the percentage returns that we must focus in on. For example, if we generated a 2% 1-month return on 10 contracts of a $10 stock or 2% of 2 contracts of a $50 stock, we end up with a $200 profit. Quality should take precedence of quantity. A very minor point is that commissions may actually be higher for multiple contracts of less-expensive stocks.

      That said, there are some high-quality, low-priced stocks that we should consider.

      Alan

  8. Brian December 29, 2015 11:02 am #

    Alan,

    I am getting started with your books and stock recommendations. What should the course of action be when holding a position that was eligible last week and not eligible this week?

    Thanks,
    Brian

    • Alan Ellman December 29, 2015 11:05 am #

      Brian,

      Once a position is established, it is managed as described in my books/DVDs, not by its presence or lack thereof on our Premium Watch Lists. Since we are in both long stock and short option positions, it begins with adhering to the 20%/10% guidelines.

      Alan

  9. Alan Ellman December 29, 2015 5:16 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Wishing you and your families a happy, healthy, wealthy and safe New Year,

    Alan and the BCI team

  10. John Henderson March 19, 2016 3:44 pm #

    Hi Alan,

    I just got your ebook “Options Greeks” and embarrassingly, I still don’t get what this means.

    Short A Call. (In reference to Covered Calls)

    You say in Options Greeks book: “When we are writing covered calls, we are long the stock and all shares have Deltas of 1. When we sell the call options, we are short the calls,…”

    Why are we short the calls? My understanding of being “short” is from Investopedia, where it says, “shorting” is where we borrow shares because we think a stock is going down, (you sell them), and then you purchase the shares at the now cheaper price and sell them back to your broker, keeping the profit.

    So, why are you saying we are “short the calls” in reference to selling a call option? I own the stock (100 shares per contract) and so I’m not borrowing anything from anyone, so selling a Covered Call, how is that “shorting a call”, or “short the call” as you said?

    Thanks in advance for clearing this up.

    • Alan Ellman March 19, 2016 4:59 pm #

      John,

      The term “shorting the call” means that we sold an option we never owned to begin with. Although you point out correctly that we do own the shares first (long the stock), we do not own any options to sell. We are in two positions. By owning the shares before selling the option, we are protecting ourselves in that we know the cost basis of the shares we are agreeing to sell. So to sell options we never owned, we are “borrowing them” on paper at least and that is why our brokerage statements show the option sale as a debit (minus sign) until the option is bought back, exercised or expires worthless.

      Alan

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