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

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