• Trading 101: Volatility Implosions

    by  • January 29, 2013 10:47 am • Trading 101 with Peter Bryans • 1 Comment

    There are a slew of earnings reports this week, and I have written previously about how one should trade around these events if you feel uncomfortable holding through a quarterly announcement. With options trading, you will, more often than not, find yourself paying up to purchase either a put or a call around a company’s earnings release.

    Let’s take a look at a company that reported before the market opened today, January 29th, 2013. U.S. Steel (X) is featured below, and after glancing at this daily chart (that begins in April and runs until yesterday’s close) you can see that it has been a rather volatile name.

    (chart courtesy of eSignal–click to enlarge)

    Below is the option chain for options that expire this Friday, February 2nd. Remember the importance of implied volatility (IV) and how this cost is embedded in an option premium. IV is the market’s forecast of future volatility of the underlying security (X), and for U.S. Steel, you can see that the at-the-money (ATM) and near-the-money options are rather pricey, as they have little or no intrinsic value. Listed are the bid price, offer (ask) price, and the IV. Calls are on the left, puts on the right. U.S. Steel closed at $23.72 after the close on Monday, January 28th, 2013.

     (courtesy of eSignal–click to enlarge)

    The ATM call and put options (23.50-strikes, because X closed at $23.72), have IV’s of 74%. To give you a point of comparison X’s 10-day and 30-day historical volatility (HV) are 30% and 43%, respectively. Clearly, future forecasts of volatility (IV’s) are much higher than the HV for this equity. No surprise, given the looming announcement.

    Below is the option chain once the market opened. Note the change in IV’s from the above snapshot and the resulting decrease in the bid and ask prices for the options that are ATM or near-the-money. This was taken at approximately 10:35 AM on 1/29/13 where U.S. Steel was trading at $23.56—it was down $0.16 (from its close of $23.72), but the put options (note the 24 & 23.50 strikes) were actually worth less than after the previous day’s close (Monday).


    (courtesy of eSignal–click to enlarge)

    If you are going to purchase a call or a put, you better be expecting a big move, and you also better be confident that you are on the right side of that move. The risk that comes with purchasing an option ATM or near-the-money is that even if the equity moves in your favor, you can still lose money on the premium you purchased. If a stock gains more intrinsic value, but does not move enough, you will experience what is called a volatility implosion—all of the implied volatility will be dramatically reduced and the extrinsic value of your call/put will decline in value. The post-earnings announcement will dramatically drop the market’s forecast of future movement (IV) in the underlying security (which in this case is U.S. Steel).

    Playing options can be a risky game—and trying to purchase calls/puts around earnings can be an even riskier play. I cannot emphasize enough the importance of understanding all of the unique and complex characteristics of options, so be sure you are knowledgeable before trading them!

     

     

    About

    Peter Bryans joined the Schaeffer's Investment Research trading team as a Trader in April, 2012. A graduate of the Fisher College of Business at The Ohio State University -- where he concentrated in Finance -- Peter previously held internships with an insurance broker and a wealth-management firm. In his current role, Peter trades a variety of our real-time option services and also hosts our "Options Apprentice" weekly webinar presentations.

    http://www.schaeffersresearch.com

    One Response to Trading 101: Volatility Implosions

    1. February 1, 2013 9:54 am at 9:54 am

      Understanding volatility remains a challenge. This was a good article to help be aware of it at earnings time.

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