Three Factors That Affect a Call Option's Value

by Rocco Pendola

When you trade options, including calls, you are betting not just on the value of the underlying stock, but on the value the option will have to potential buyers. At times, you can make the correct guess on what direction the stock will move, for instance, but the value of the option contract does not move as you expected. The three most significant factors in valuing options are "time decay" and what traders term "the Greeks," particularly Delta and Gamma.

The Basics

A call option is the right to buy a security at a certain price -- known as the strike price -- on or before the option's expiration date, though there is no obligation to do so. At day's end buying a call mimic buying 100 shares of the underlying stock, but at a fraction of the cost. You can overpay for a call. If you do, the option's underlying instrument may move up, but you can still be left with a losing call option position.

Time Decay

Generally, the further away you are from your call's expiration date, the higher its premium. As you get closer to an option's expiration day, the value of the call tends to decline. Options traders refer to this erosion in value over time as "time decay." One way to understand this is to consider an out-of-the-money call option. When a call is out-of-the-money, it's strike price is above the underlying security's market price. As you get closer to options' expiration day, the likelihood that an out-of-the-money call will go in-the-money (the market price will be higher than the strike price) decreases, therefore the value of the call does the same.

Delta

In valuing options, traders use five measures of risk -- Delta, Gamma, Vega, Theta and Rho -- known as the Greeks. Of these, Delta might be the most important, at least with respect to how it influences the value of a call. Delta measures the rate of expected change in an option for every one-unit change in the option's underlying security. For instance, if an option's Delta is .70, it will move .70 (or 70%) for each one point move in the underlying equity's share price. A low Delta often indicates that you will need to see large movements in the underlying stock to realize meaningful movements in the value of an option.

Gamma

Gamma refers the amount of change you can expect in an option's Delta for every one point change in the price of the option's underlying security. For instance, a Gamma of .20 means that Delta will increase by .20 for every one point move in the underlying stock. Because Gamma impacts Delta, a high Gamma indicates that Delta will also increase as the underlying security moves, which means that the value of your option might end up making larger moves as well.

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