Recently, I've been thinking that I should stop myself from drifting more and more into the Greeks of option trading. I'm horrifying new options traders, I told myself. I'm going too far.

Then I got another email similar to one I've received periodically. Usually those emails are from subscribers asking me why their option's price hadn't appreciated as they expected, even though the underlying had gone in the right direction within a time frame that should have made the option trade a profitable one. This time, the email came from an experienced options trader who had a pretty good idea what had happened and was only bemoaning the fact that it had happened during this particular trade.

The emails usually go something like this: I bought a call on (you supply the underlying), and (the underlying's) price went up $2.00 in two days, but my option hasn't gained any value.

What's going wrong? I deliberately used a call in this example because calls seem to suffer this fate more often than puts. Why? When the underlying's price is rising, volatility is often dropping. Long calls are a vega-positive trade, which means they gain in value when volatility rises and lose value when volatility drops. In addition, long calls are theta-negative. Theta relates to the passage of time. A negative theta position means that, as time passes, the call will lose value if no other parameters change.

In our example, the underlying had gained two points in two days, but it's possible that dropping volatility and the passage of time both devalued the call, working against the beneficial effect of the rising price.

For example, on Tuesday, June 17, IBM again broke above a rising trendline that had proven to be resistance on daily closes since May 20. On that Monday, IBM had popped above that resistance but had fallen and closed near the low of the day, back below that rising trendline.

Annotated IBM Daily Chart:

Imagine that when it became apparent that IBM was going to hold that breakout into the close, you decided to buy a JUN IBM call, with the mid price of that call at about $0.87 near the close. For the sake of this article, we'll use mid prices although I understand that it's not always possible on all vehicles at all times to get mid prices. That option had a delta of 0.4697 or 46.97, depending on whether your quote source automatically applies the 100 multiplier. If all other parameters remained the same from that point forward, you could expect that option to gain about $0.47 for each point IBM gained. Of course not all parameters were going to stay the same, and we'll discuss those as the article develops.

You were right about your assumption that IBM would continue to climb, as the chart shows. IBM had closed at $129.79 on June 15. By the close on June 17, it was at $130.98. IBM had gained $1.19 in those two days. If all other parameters were the same, that call should be expected to gain about $0.56, to $1.43.

However, as of the close on June 17, that option was valued at only $1.12. By the time two-way commissions were applied, there wasn't going to be much of a profit on that position. In fact, one calculator shows that, if one was using $1.25 commissions each way, a one-contract purchase would have netted you a whopping $23.50, and that's only if you were able to secure mid price on both the buy and the sell of that option.

What happened? Two very obvious things happened: time passed and volatility decreased. Time decay took a heavy toll since it was expiration week for those options, with time decay speeding up as expiration approaches. Volatility tends to decrease when prices rise, and it did this time, too. The implied volatility of that option was 20.66 percent on June 15, and only 17.28 percent on June 17. Volatility tends to collapse as expiration approaches, too, with the value of the option collapsing to its intrinsic or in-the-money amount.

This is what the Greeks would have told us to expect upon entering the trade. On June 15, theta was -16.16, which meant that the option would lose $0.16 to time decay overnight. Theta had escalated to -20.06 the next day, meaning that it would lose another $0.20 to time decay overnight. By June 17, that option could be expected to have lost about $0.36 from time decay alone. Vega was smaller but would add its impact, too.

In addition, sometimes options traders are unwittingly buying an expensive option. Not long ago, I addressed what can happen at the open, when volatilities are pumped up and option prices inflated. That's one case when options can be expensive, but others exist. If you watch the options prices in the underlyings you trade most frequently as the underlying's price approaches important support or resistance, you'll sometimes notice the same pumping up of volatilities and inflating of options prices. In markets were market makers are active, those market makers may be protecting themselves from a breakout or breakdown, widening bid and ask prices and pumping up the volatilities. Retail and other traders may be adding to the effect by piling into puts or calls either as insurance or as speculative trades. As soon as the breakout or breakdown is confirmed, that volatility may collapse.

In underlyings that will be impacted by an economic or geopolitical event, similar effects can be seen. I've noticed SPX and OEX volatilities pumped up just before an FOMC announcement, even though SPX and OEX prices may have stymied just above or below support or resistance. The underlying's price may not be changing much, but that doesn't mean that the options' volatility is static. How about a pharmaceutical awaiting a decision on a drug trial? Those options will likely be inflated but the volatility will often collapse right after the decision is announced. Market makers will have already priced in the expected move, either direction, and unless the underlying moves more than that, you're not likely to see your option price increase much, even if price is moving in the direction you thought it would.

Option Investor has always advised most traders against holding options over an earnings announcement due to this effect. Prices may stagnate before the announcement, but again that doesn't mean that option volatilities have. They tend to begin inflating days and sometimes even weeks before the earnings announcement, with the amount of time that process goes on varying from underlying to underlying. You can price an ATM straddle (long call and long put) and see where the market makers think the underlying's price could go in either direction. Unless the underlying's price moves further than that, you're not likely to benefit much from a long option purchase.

Although the first example I used in this article related to a call, the implied volatility of puts can drop, too, in some of the circumstances I've just mentioned. Under many--and maybe most--circumstances, a put's implied volatility might be expected to rise as the underlying's price drops, that's not always true in some of these cases in which the implied volatility was already abnormally elevated at the time the option trader purchased it. Even when the implied volatility wasn't abnormally elevated, a gentle drop over time might see implied volatilities steady while time decay eats away at a put's value. Puts aren't immune from these effects that sometime puzzle option traders.

Although I sometimes worry that I'm spending too much time talking about the Greeks of options, that email I received this week echoed ones I've received for years. If you're only thinking about price and maybe even if you're adding in timing, too, which most option traders do, you're missing something important. That's the impact that changes in volatility can have on your option's price. I don't often suggest that traders run scans to compare implied volatilities to historical volatilities and automatically buy "cheap" options when that ratio is low and automatically sell "expensive" options when that ratio is high. For most traders, it's best to become familiar with a number of preferred trading vehicles rather than to run such scans and jump on an option trade on an unfamiliar vehicle due to the results of such a scan. However, do get to know how options on your vehicle react to changes in volatility. If the VIX (or VXO or VXX) is headed up or down, your OEX or SPX trade may be impacted. Big-cap stocks may be, too. If the RVX is headed up and down, your small cap options trades may be impacted. If BP is headed into another round of hearings, volatilities may be hiked up previous to those hearings. If your pharma stock's main competitor is about to release results of a wonder drug, your pharma stock's options may inflate in price previous to that announcement, too.