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The Measurement Every Option Trader Should Check During Earnings Season
10/27/2010 12:01 am EST
By Josip Causic, instructor, Online Trading Academy
Last week, I was teaching an option class, and during that week, many companies were releasing their quarterly earnings. As I was working with the class on the topic of short vertical spreads and looking for an example, the students insisted on using Apple, Inc. (AAPL) and I obliged.
After briefly checking the current reading of Apple's implied volatility (IV) against Apple's historical 52-week high and low volatility, I chose to entertain the possibility of placing a short vertical on AAPL in the simulated account a day before its earnings release. The IV reading versus historical is listed in the figure below.
After pulling up the data from the CBOE Web site, which in turn is powered by IVolatility.com, the conclusion was made that AAPL's IV was not necessarily at its highest point, but rather in a higher range. Therefore, we deemed AAPL as a suitable candidate for our paper trade. Checking the IV is only one of the many steps involved in option trading; doing an in-depth technical analysis is another.
Once the chart was pulled up, it was clear to all the students that AAPL has been in a strong uptrend for a while. The fact that on October 18, 2010, the candlestick closed as a “hanging man” did not mean much, for even if there was about to be a pullback, most likely it was to be short-lived. For simplicity's sake, I have inserted the chart below.
On the chart, I have drawn the primary and secondary trend lines, the latter one being much steeper, angle wise. Moreover, on the chart, I have plotted a moving average that AAPL has obeyed in the past. The green simple moving average was coinciding with the secondary diagonal trend line. In addition, we have selected a round, psychological number as our possible support. The 300 level, marked on the chart with a light blue oval, also overlapped with the previously mentioned levels of support.
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Strike price selection was done after support was clearly identified. The 300 put was sold, and for protection, the 290 put was bought. By the way, AAPL strike prices listed are in ten-point increments. For the expiry, we chose the shortest possible time for our obligation to have a short vertical on, which was the October weekly option. The premium on these strike price was inflated:
Although the specifics of the trade are listed above in both Figure 3 and on the chart, it is important to emphasize that this trade was a bullish trade, also known as a bull put. The trade was placed on Monday before the earnings release (ER), and in four days, the rate of return (ROR) if AAPL closes above $300 would be 33%. To calculate ROR, simply divide the maximum profit by the maximum loss (2.50/7.50). Also, to calculate the break-even point (BEP), subtract the credit received from the sold strike, $300 - $2.50 = $297.50.
Interestingly enough, on the day of entry into the position, AAPL was trading around the $314 -$315 area, and we sold a bull put on AAPL before the earnings release. By selling the 300 put, we took an obligation to buy the asset for $300 per share while AAPL was trading around $315. Having a sold strike price that far removed from the current asset price means that APPL could go down 15 points before seriously hurting us; once again, our BEP being 297.50.
The very next day it gapped down almost 15 points. As the students were coming to class on the morning of October 19, 2010, they all expected to see a loss in the paper trading account due to the fact that this trade was bullish and it had gone bad because of the gap down. The day after the earnings release, AAPL opened 15 points lower. This did not affect our position because we had sold our bull put before the release when IV was high. The day after the earnings, IV dropped significantly.
The figure below compares the entry with the morning of October 19, 2010.
Had we closed the position by buying back the whole spread, the cost of closing would be 1.03, meaning that we did not make the max profit of 2.58, but about half of the max profit. Once the rate of return is calculated, it appears as a 20% gain.
The very last figure shows the drop of AAPL's IV the day after the earnings release. As can be observed, the volatility dropped from 42.50% to 27.86%, which is the current reading as of October 21, 2010. This drop of 14.64% is the main reason why we were able to buy back the sold vertical spread for so little. When it was sold, the premium was at its highest. Since then, AAPL has rallied, and, in fact, closed above the $300 zone.
In conclusion, this article has shown an example of how much a huge drop in the implied volatility right after the earnings could affect option premium prices. Knowing where to check for the IV readings (CBOE Web site) and knowing not to be a buyer when the IV is high and the option premium inflated is a major part of option trading.
By Josip Causic, instructor, Online Trading Academy
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