Beware of Implied Volatility Crush

The price of an option is calculated with a complex formula that takes into account the strike price, the stock price, time to expiration. Each of these is well defined. However, an additional variable comes into play, and that’s the implied volatility. I like to refer to implied volatility (IV) as the “excitement factor”. How excited are people about making money with the options. If it is the week of an earnings announcement there is a lot of excitement in the air, and the value of implied volatility can skyrocket, taking the option price with it.

Let’s look at a recent Amazon (AMZN) earnings announcement and the option prices before and after the announcement. AMZN announced earnings after the market closed on October 25, 2012. There was lots of excitement that week, with the implied volatility of a weekly at-the-money option approaching 100%. But the day after earnings, the at-the-money option had an implied volatility of 32%. These massive swings in volatility make it difficult for a beginner to trade around earnings.

Let’s take a typical “beginner trade”. Suppose Bob “knows” that AMZN is going to have a blowout quarter, so he buys a weekly call option out-of-the-money so he gets the most bang for his buck. With AMZN trading at 223, he buys the Nov1 230 Call because it is cheap, only $10.25 He doesn’t notice that the implied volatility (the excitement factor) of that option is 95%. He watches the earnings announcement that evening, and is ecstatic because he was right. AMZN jumped 16 points after hours. He was going to make a fortune. Unfortunately, the next day, the implied volatility on his option had been crushed (35%) and he could only sell his option for $9.90. If IV had remained constant, he would have made 80% in a day! He would have taken his $1,025 investment and made $800. But when the implied volatility collapsed, he ended up losing $15. That’s right. You can buy a call option, have the stock pop up 16 points and still lose money!

So how do you trade earnings and avoid having your options crushed when the IV falls? For beginners, I would recommend several rules. First, don’t trade earnings! It is very difficult to make money consistently. Second, if you must, don’t trade weeklys. Again, very difficult. Third, don’t buy out-of-the-money call options. You are requiring a significant price movement in the right direction to make any moneyThe only way I would trade earnings announcements would be with a vertical spread trade at least 30 days out in time. By going out in time, I don’t have such a sharp fall in implied volatility after earnings. By using a spread, I buy an option and sell an option, so the change in implied volatility of one option is largely cancelled out by the change in the other.

Trading earnings profitably is very difficult. The implied volatility of short-term options rises leading into earnings and then falls dramatically the next day. The value of long options falls as well. If you buy the day before, and sell the day after, you will usually lose money, even if you are right on the direction of the post-earnings move.

Submitted by John Marsland

Be Sociable, Share!

Related Posts

 

MarketTamer is not an investment advisor and is not registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory Authority. Further, owners, employees, agents or representatives of MarketTamer are not acting as investment advisors and might not be registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory.


This company makes no representations or warranties concerning the products, practices or procedures of any company or entity mentioned or recommended in this email, and makes no representations or warranties concerning said company or entity’s compliance with applicable laws and regulations, including, but not limited to, regulations promulgated by the SEC or the CFTC. The sender of this email may receive a portion of the proceeds from the sale of any products or services offered by a company or entity mentioned or recommended in this email. The recipient of this email assumes responsibility for conducting its own due diligence on the aforementioned company or entity and assumes full responsibility, and releases the sender from liability, for any purchase or order made from any company or entity mentioned or recommended in this email.


The content on any of MarketTamer websites, products or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options and other securities involves risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities is not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options. The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.


The information presented in this site is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing in our research constitutes legal, accounting or tax advice or individually tailored investment advice. Our research is prepared for general circulation and has been prepared without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it. Our research is based on sources that we believe to be reliable. However, we do not make any representation or warranty, expressed or implied, as to the accuracy of our research, the completeness, or correctness or make any guarantee or other promise as to any results that may be obtained from using our research. To the maximum extent permitted by law, neither we, any of our affiliates, nor any other person, shall have any liability whatsoever to any person for any loss or expense, whether direct, indirect, consequential, incidental or otherwise, arising from or relating in any way to any use of or reliance on our research or the information contained therein. Some discussions contain forward looking statements which are based on current expectations and differences can be expected. All of our research, including the estimates, opinions and information contained therein, reflects our judgment as of the publication or other dissemination date of the research and is subject to change without notice. Further, we expressly disclaim any responsibility to update such research. Investing involves substantial risk. Past performance is not a guarantee of future results, and a loss of original capital may occur. No one receiving or accessing our research should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence, including carefully reviewing any applicable prospectuses, press releases, reports and other public filings of the issuer of any securities being considered. None of the information presented should be construed as an offer to sell or buy any particular security. As always, use your best judgment when investing.