Now that earnings season has started, I thought it would be a good time to discuss the importance of volatility in options pricing.
I think of volatility in terms of insurance. If there are reports of a possible hurricane coming in the direction of your house, you would likely be willing to pay extra to have as much insurance as possible in case of mass destruction. However, once the threat of a hurricane has passed and your house is safe, you would have no interest in having extra insurance because of the added expense.
This is similar to how options are priced right before and after earnings reports.
Earnings reports are among
the great unknowns of investing. Will company XYZ’s quarterly profits top analysts’ expectations? Will its revenues come in line? Are there any other important inputs in its business that could make the stock move violently in either direction?
Because we don’t know the answers to these questions until after the report is released, options prices often rise as traders buy volatility/insurance to hedge against big moves in the stock. However, once the earnings are reported, volatility and options prices will drop DRAMATICALLY. Just like after the hurricane passes, uncertainty is removed after earnings are reported because we then know how the business is doing and can more properly measure the value of the company and the stock.
As an example, let’s look at the impact of volatility in the pricing of JP Morgan Chase (JPM) options. The company released earnings on the morning of April 12 and the figures topped analyst expectations.
JPM shares closed on April 11 at 49.31, and then traded at 49.15, down 0.16 the following morning.
Here are the JPM options that were close to at the money and their prices before and after the earnings announcement:
April 50 Calls: $0.47 before earnings; $0.17 after earnings.
April 48 Puts: $0.28 before earnings; $0.13 after earnings.
May 50 Calls: $1.00 before earnings; $0.76 after earnings.
May 48 Puts: $0.80 before earnings; $0.67 after earnings.
As you can see, if you bought any of these options—including puts which you might assume would be worth more with the stock down following the report—you would have lost money. This was due to the dramatic decrease in volatility after the company’s earnings announcement. The hurricane had passed.
The dramatic decrease in volatility following earnings announcements is why I sometimes recommend spreads to lower volatility and premium risk. Buying one option and selling another lowers our volatility and risk if we get the trade wrong. (That being said, when we use spreads, we also limit our potential gains if the stock makes a dramatic move.)
— Advertisement —
Double Your Money Every 21 Days
Cabot Options Trader uses the market's volatility to bring subscribers huge profit-making opportunities. Just check out these gains:
* 94% gain on a Freeport McMoRan (FCX) Call in only 3 days!
* 100% gain on a Goldcorp (GG) Call in 8 days!
* 190% gain on a Cisco (CSCO) Put in 7 days
Subscribers are leveraging small stock moves into big profits on both the up and the down sides. Test-drive Cabot Options Trader for 60 days FREE and lock in our lowest price ever—just $1.61 a day. Why not grab these quick gains for yourself?
Now let’s take a look at a stock where options volatility was not high enough going into earnings. Infosys Technologies (INFY) made a massive move last Friday after the company released disappointing earnings. The hurricane made a direct hit on this stock.
INFY shares closed last Thursday night before the earnings release at 54.42, and traded at 43.61, down 10.82 the next morning.
Here are the INFY options that were close to at the money and their prices before and after earnings:
April 55 Calls: $2.00 before earnings; $0.05 after earnings.
April 52 Puts: $1.50 before earnings; $9.00 (!) after earnings.
May 55 Calls: $2.50 before earnings; $0.05 after earnings.
May 52 Puts: $2.00 before earnings; $9.00 (!) after earnings.
As you can see, volatility was priced too low and put buyers were rewarded handsomely.
In conclusion, volatility is much like insurance. It is a terrible waste of money that sucks away your hard-earned cash every month … until your house/stock gets hit by a hurricane.
If you have any interest in portfolio protection or the type of insurance I spoke of, check out Cabot Options Trader, where I regularly talk about how to hedge your portfolio against hurricanes. For details, click here.
Your guide to successful options trading,
Analyst and Editor, Cabot Options Trader