Lesson 17 of 20 · 7 min

Right about direction, wrong about money

An option can lose value while the underlying moves exactly the way its holder wanted.

This is the experience that convinces many people options are rigged. They are not; the position simply had more than one variable in it, and only one of them went the right way.

An option's premium responds to at least four things simultaneously: the underlying's price, the time remaining, the market's implied volatility, and interest rates. A holder who is focused on price is holding a position that three other forces are also acting on. Two of those, time and volatility, commonly move against a holder at the same moment.

The three ways to be right and still lose:

The move was too slow. Extrinsic value decayed faster than intrinsic value accumulated.
The move was too small. The premium paid embedded a larger move than the one that happened.
Implied volatility fell. The most common version: an anticipated event resolves, uncertainty collapses, and every contract on the underlying reprices downward regardless of direction.

The third case is worth naming precisely because it is so counter-intuitive. Before a scheduled event, premiums embed elevated implied volatility because the outcome is unknown. Once the outcome is known, the uncertainty is gone whether the news was good or bad, and the volatility component of every premium contracts. A holder can be correct on direction, see the underlying move their way, and still find the contract quoted lower than they paid. Track 3 develops this as vega and volatility crush.

Being right about the underlying is necessary and not sufficient. The premium was a price for a specific size of move within a specific time at a specific level of uncertainty.

Key terms

Implied volatility: The level of expected movement embedded in an option's market price. It rises and falls independently of the underlying's direction.
Volatility crush: The rapid fall in implied volatility after an uncertainty-resolving event, which lowers premiums across the chain.
Breakeven move: How far the underlying must travel, by expiry, for the position to be worth what was paid. Always larger than zero.

Worked example

The stock rose 4% and the call fell 48%

A $52.50 call held into a scheduled announcement. Underlying $50, 10 days to expiry, implied volatility 75%, rate 4%.

Premium paid: $1.50
After the event: underlying: $52.00
Implied volatility after: 30%
Days remaining: 9
New premium: $0.77
Result: −$73 per contract, about −48%

Correct on direction, a move larger than a typical day, and down 48 percent. The volatility component did the damage.

Check yourself

You hold a call into an earnings announcement. The stock rises 4% on the news and your call is worth less than you paid. What happened?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.