Heading into earnings season, I thought it might be interesting to talk about how options work into earnings. In fact, one of the most misunderstood facets of options trading is earnings plays. There is a major misconception of how options behave into earnings. Most traders see a chart like this in RIMM and think the following:
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Well IV went up which means that the value of the options or the value of the straddle must have increased dramatically. This is not the case. To understand how earnings work, one must understand the pricing model itself. Recall that the pricing model is derived from time to expiration, forward volatility, price of the underlying, strike price, and carrying cost. They are all working parts; however, there is one factor that is especially important, volatility.
Recall that we don’t actually know forward volatility, so we use implied volatility as a replacement. IV is actually a solution to a problem that states: we know the current price of an option, and the other four factors in a pricing model, what does that mean the market thinks forward volatility is? In other words, that red line that is going up and up and up is actually an OUTPUT, not an INPUT. There are things that can affect that IV besides the cost of the option going up. There are actually 4 factors that can affect that red line increasing. Most notably, the passage of time.
If we consider options to be an insurance product, then it can make an analogy about option prices much easier. If I were to sell you a policy on a car that expired in one year, you would expect it to have a different price (probably higher) than a policy that expired in 6 months. Options, via the pricing model, assume the same thing. There is an assumption that every day that passes an option will lose some time value (this is what all of you so called income traders are trying to take advantage: BTW, do income traders think that option buyers aren’t trying to make an income, seems like a silly term doesn’t it?).
What if time passes and the option itself does not lose value? What then? The model is essentially not working right in this scenario. Something must be done in order for the model to calculate the right option price. Since we can’t add time, increase the price of the stock, change the strike price, or affect the cost of carry, the IV (which is an OUTPUT) goes up.
This is important because, I think, it better puts into perspective the concept of IV moving up into earnings. In fact, IV does move up into most earnings announcements, but it is usually not because an options price is going UP, but more often because an option price is NOT GOING DOWN. Lack of decay forces option IV’s to increase. We saw this in RIMM this week:
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Take a look at the straddle price of the April options since they listed. Notice that IV leading into yesterday’s announcement was really high, but, in fact,there was little to no increase in the options prices themselves. Options, typically, act more like the above into earnings than some ‘bid up.’
Basically, the market picks a straddle price for an earnings announcement LONG before that announcement occurs. The straddle value is typically embedded into the straddle and does not decay out. There are times where that price may go up or down: an actual so called ‘bid up’ can occur. However, they are far more rare than many traders realize. Most of the time, the IV is simply increases, because the price of the straddle isn’t decreasing. Once the announcement comes out, THEN the embedded straddle will be pulled out of the options that bring us the major drop in IV that we are used to seeing (that actually is a drop in the value of the options).
Understanding this can make traders MUCH better at trading around earnings, and using earnings months as good ‘long anchors’ against other months. It also can point toward why it can be okay to sell premium in an earnings month (just be out before the actually earnings announcement). It can also point toward the flawed thinking that it makes a lot of sense to go in and buy options ahead of earnings, because the IV is going to go up. The IV may go up, but the straddle price might not. There are specific times where a bid up does occur; however, as we stated above, they are quite rare.
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