Volatility in Options Pricing at Earnings

 

Volatility in Options Pricing at Earnings
How Calls and Puts are Priced
Example: AAPL Options Pricing

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Many novice options traders understand what a call is. It’s the right to buy a stock at a specified price at a specified time. Fewer understand what a put is. It’s the right to sell a stock at a specified price at a specified time. But how is the price of that call/put determined?

To calculate an options price/value, several variables are needed including the amount of time until the option’s expiration, interest rates, dividend rate and in my mind the most important, volatility.

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 its added expense.

This is similar to how options are priced right before and after earnings.

Earnings reports are one of the great unknowns of investing. Will company XYZ’s quarterly profits top analyst expectations? Will its revenues come in line? Are there any other important inputs in their business that could make the stock move violently in either direction?

Because we don’t know the answers to these questions until the earnings report is released, options prices often rise as traders buy volatility/insurance to hedge against big moves or the unexpected. However, once the earnings are reported, volatility and price will drop DRAMATICALLY. (Just as after the hurricane’s passed, there’s no longer uncertainty.) After earnings are announced, we know how the business is doing, and can more properly measure the value of the company and the stock.

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AAPL Options Pricing

As the editor of Cabot Options Trader, several times a week I write educational pieces to help my novice to intermediate experienced readers learn about the intricacies and nuances of options trading.

Here is an options education piece I wrote earlier this year on how AAPL options performed in April 2013 at the Apple’s earnings announcement. The purpose of the piece was to show how important volatility is in the pricing of options:

Apple (AAPL) is due to report earnings this evening after the close. The stock has been in a steep decline over the last several months. It traded as high as 700 in late 2012, and is today trading at 405.

So let’s take a look at what the options market is pricing in for AAPL’s expected move after its earnings are released.

Volatility is sky high! Based on the pricing of the weekly options, those that expire this Friday, the options market believes AAPL will move 30 points tomorrow. This seems like fair pricing to me. I don’t necessarily want to be short a lot of options, and I certainly don’t want to be long options because of the inevitable volatility destruction tomorrow. (Think of the hurricane passing.)

I am going to pick some random strikes for us to follow to see how they perform if we had bought or sold them. Also, I will make note of the current volatility pricing on a couple of longer options. I will update these positions in a follow up tomorrow.

Volatility for various expiration months
April 26 volatility: 100
May 18 volatility: 44
June 22 volatility: 35

Strikes to follow
April 26 expiration:
410 Calls $12.50
400 Puts $12.50
445 Calls $2.10
375 Puts $3.80

May 18 expiration:
410 Calls $15.50
400 Puts $17.00
470 Calls $2
340 Puts $1.5

June 22 expiration:
410 Calls $19.50
400 Puts $21.50
500 Calls $1.70
300 Puts $0.75

AAPL Follow-up:

Apple (AAPL) reported earnings last night after the market close. The consensus reaction is mild disappointment.

Right after the numbers were released, the stock shot up nearly 30 points before slowly drifting down during the company’s conference call.

This morning, there were reductions of price targets for the stock, and the stock opened down approximately 12 points. Right now, the stock is virtually unchanged from yesterday’s closing price.

So let’s see how the options we picked yesterday performed.

Volatility for various expiration months
April 25 volatility was 100; now it’s 41, which is down 59 points on the day
May 18 volatility was 44; now it’s 31, which is down 13 points on the day
June 22 volatility was 35; now it’s 28, which is down 7 points on the day

Strikes followed

April 26 expiration:
410 Calls were $12.50; now they’re $3.00, a loss of $9.50
400 Puts were $12.50; now they’re $3.00, a loss of $9.50
445 Calls were $2.10; now they’re $0.10, a loss of $2.00
375 Puts were $3.80; now they’re $0.20, a loss of $3.60

May 18 expiration:
410 Calls were $15.50; now they’re $9.00, a loss of $6.50
400 Puts were $17.00; now they’re $11.00, a loss of $6.00
470 Calls were $2.00; now they’re $0.50, a loss of $1.50
340 Puts were $1.50; now they’re $0.50, a loss of $1.00

June 22 expiration:
410 Calls were $19.50; now they’re $14.50, a loss of $5.00
400 Puts were $21.50; now they’re $17.00, a loss of $4.50
500 Calls were $1.70; now they’re $1.00, a loss of $0.70
300 Puts were $0.75; now they’re $0.50, a loss of $0.25

In conclusion, AAPL had the 30-point move that the options market was implying, though the whole move occurred before the market opened.

Also, EVERY option we were watching was a MASSIVE loser. Volatility in these options was destroyed after the earnings release—this is what makes buying straight calls and puts for earnings in an elevated volatility environment difficult.

To combat this volatility destruction, I often use spreads, which is a great way to minimize volatility and premium risk.

If you are new to options and want to continue to build your understanding, I recommend that you do a similar exercise. Choose a stock with earnings, theorize an options strategy you might want to use, write down the prices before and after earnings, and evaluate how your strategy performed.

Your guide to successful options trading,

Jacob Mintz
Chief Analyst, Cabot Options Trader


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