Why does premium matter after purchase?

C

Carbonator

Hi Guys,

I picked up the book "The Option Trader Handbook" the other day wanting to learn a bit more about options. It turns out, though, that this book may be on a slightly more advanced level than suits me at my level of knowledge.

In the book it is described (upon writing about Implied Volatility) that if one purchases a relatively expensive call option, and the Implied Volatility comes crashing down resulting in lower premiums, a stock would have to move even higher in order for the investment to turn out profitable. This, to me, is weird as I thought you only paid the premium upon initial purchase. If I do not close out the option by exercising it at some point, why does a lower premium (now versus when I purchased the option) have any influence on my profits? Wouldn't changes in premium only alter my P/L if I closed out my position?

If anybody knows the answer to this one, I'd be grateful to have your answers. If anything is rendered unclear, please notify me so that I can make myself clearer. Thanks.
 
Quote from Carbonator:
This, to me, is weird........
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1) Your expiration break-even point does not change.
2) However, before expiration, you'll need more price movement in order to offset the volatily decay. That's true.
3) Scenario-1: You paid $5 for a 60-strike call when the stock was at $50. If implied volatility remains firm and the stock rallies, your call-option should increase in value tick-for-tick with the stock by the option's delta.
4) Scenario-2: Your call option declines to $3, with the stock unchanged at $50. In order to get back to a $5 premium, the stock will have to rally atleast $4, (assuming an option delta of 0.50, $4x0.50=$2, $2+$3=$5), up to $54/share. In scenario-1, the option increases in value from only $50/share on up. Even worse, the implied volatiltiy will probably decline further on a price rally. :cool:
 
Quote from Carbonator:

Hi Guys,

If I do not close out the option by exercising it at some point, why does a lower premium (now versus when I purchased the option) have any influence on my profits? Wouldn't changes in premium only alter my P/L if I closed out my position?
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1) You do not have to hold the option until expiration. You are allowed to sell it at any time.

2) Do not think in terms of 'exercising' to close the position. You will almost NEVER want to exercise. The plan is to sell the option at some point in time.

3) If the option premium INCREASES, you can sell it at a profit right away.

Example: You pay $4 for a call option.

If the stock moves higher, you anticipate that the option will also increase in value. And it does - much, but not all, of the time.

So, if the option is trading at $4 and the stock moves higher, you may decide to sell the option when it reaches $6. You will not care how high the stock has moved, if you are happy to collect $6 for the option.

However, if the option premium drops to $3 - even if the stock is unchanged and even if no time has passed, then in order for the option to climb to $6, the stock price must more more than it would have had to move if the option were still priced at $4.

In other words:

The stock must move higher by MORE to make the call option move from $3 to $6 than it has to move to make the call option increase in value form $4 to $6.

4) If you want a well-written book written for the beginner, check out this review:
http://www.condoroptions.com/index.php/books/the-rookies-guide-to-options-review/

Mark (I wrote that book)
 
Quote from nazzdack:

Mark, You're shameless and evil.
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You have got to be kidding me.

Budwick's book is excellent, but not for the novice.

My book is top rated, even though the number of ratings is still not large. Those who read the book tell me how much it has helped and thank me for having written it.

There is nothing shameless about letting a rookie know that there is a book out there that can be a great benefit to him. Just because you are stuck in a time warp doesn't mean that everyone else has to be.

I am a positive influence on this board. i provide simple, detailed answers to questions in language that others can understand. i don't talk down to them as some others do.

As to 'evil' - that is so preposterous that I have no words to respond.

Look to your inner self to discover why you have a need to lash out at me. It's your problem and I hope you can solve it.

Mark
http://blog.mdwoptions.com/options_for_rookies/
 
Guys, you saved my life! Thanks so much!

Nazzdack,
Although the Greeks and I are not the best of friends, I think I'm following you on this one (due to your well described scenarios). Thanks so much!

Mark,
I will definitively look into your book - it might be just what I need at this point! :)
A big thanks to you, too!
 
Your thinking along the lines I did not too long ago and here is what I know now: XYZ stock is trading at $50 today. If you buy a 60Call on XYZ stock for a premium of $5 and IF you plan on holding till expiration (naturally that is what I thought you do when I first read about options) you will need XYZ to rise to $55 at expiration to break even on the trade. Anything more is profit, less is loss up to the five bucks you paid. So you can imagine that if you buy a call on XYZ for $5 and tommorrow XYZ is still trading at the same price yet the same exact call option is $4 dollars, makes you feel like you could've gotten a better price doesn't it. On the flipside your call a few days later might be worth $7 or $8 and you may feel that you better sell now and take profit rather than risk holding till expiration where you may end up losing out. Sooner or later if you keep asking yourself the right questions it will lead you to a much better understanding of options and how they work.
 
Quote from mynd66:
......what I know now: XYZ stock is trading at $50 today. If you buy a 60Call on XYZ stock for a premium of $5 and IF you plan on holding till expiration (naturally that is what I thought you do when I first read about options) you will need XYZ to rise to $55 at expiration to break even on the trade.
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The expiration breakeven is $65 (60+5=65, strike price plus premium). :cool:
 
Quote from nazzdack:

The expiration breakeven is $65 (60+5=65, strike price plus premium). :cool:
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god dammit. Its not like I said $45 I was only off by ten.
lol j/k thanks for the correction.
 
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