Puts Don’t Make Money When Stock Falls
I am trying to understand why I did not make any money on a put option. I am hoping you can shed some light. On October 23, 2008, I bought an Xyz put option with the 15 strike price. I bought two contracts at $2.10, or $420 total. The stock dropped to near the strike price. I sold on November 11 for $1.95 and collected $390. I lost $30 even though the stock dropped the way I thought it would. How can this happen?
In order to answer your question, it is important that you understand that several factors will influence the value of a stock option, not just the stock price. Certainly, the price of the stock is often the most important. If I buy a call and the stock moves higher, chances are the call will increase in value. On the other hand, if I buy a put and the stock moves lower, the put will probably increase in value. Most traders understand this and, for that reason, many investors buy puts and calls as a leveraged or cheaper way to play moves in the stock.
While the stock price is the most important determinant of an option price, it isn’t the only one. Changes in dividends and interest rates also affect option prices. More important, changes in volatility and time also have important implications for option prices.
A stock with very high volatility will have move expensive option premiums. Why? Consider two stocks: Stock A trades in a 52-week range between $30 and $40 per share and stock B trades in a 52-week range between $10 and $90. If both stocks are trading at $35 a share, which one has a greater chance of moving to $50 over the next six months? Answer: Stock B. It is more volatile and more likely to reach that level. Consequently, a call option with a strike price of 50 on stock B will be worth more than the same option on stock A. There is a greater chance that stock B will move above $50 and the call option will be in-the-money at expiration.
While high levels of volatility make options more expensive, so does time. The more time left until expiration, the more expensive the options. For example, if stock A trades for $35 and has options listed in January and March, the March contract with the 50-strike will be more valuable than the January with the 50-strike because the March contract allows two additional months for the stock to move in-the-money.
Understanding the “greeks,” which are measures derived from an option pricing model, can help you make better sense of what is happening with your options. Many option-related websites and brokerage firms offer the ability to see and compute the greeks. Some offer both option quotes and greeks in real-time.
Delta, for example, tells us how much the value of an option contract will change for each $1.00 change in a stock price. Since puts increase in value when a stock price falls, put options have negative deltas. Call option deltas are positive. If I have a call with a delta of 0.30, it will increase in value by 30 cents for every $1.00 move higher in the stock price.
Vega captures the impact of changes in volatility and theta measures time decay. Both puts and calls have positive vegas because, as we have seen, increases in volatility make an option contract more valuable. Falling volatility has a negative impact on option premiums. Meanwhile, time decay is a negative for puts and calls. That’s why some people call options wasting assets. Both puts and calls have negative thetas.
Now, to answer your original question. The reason the put option lost value is due to the fact that, while you have delta negative when you buy a put option, you still have vega and theta risk. The stock fell as you anticipated and delta worked in your favor. However, how much value was lost due to time decay? Looking at theta will give you a clue. What about volatility? Did volatility (that is, the volatility priced into the option contract, known as implied volatility) fall? Vega will tell you how much you risk from changes in volatility. My guess is that the loss was due to a combination of both: time decay and a decline in (implied) volatility. The loss from those two factors was greater than the gain from delta.
[source: traders.com]
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