The Power of Implied Volatility & Earnings
Earnings have historically been an exciting time of year for stock traders, as many times stocks may have had large gaps up or down in reaction to a company’s earnings announcement, as well as their guidance going forward.
As we are right now in the middle of earnings season…If you’re a stock owner, you of course run the risk of an earnings miss and taking a potential large loss on your stock position. Just this morning, after their pre-market earnings announcement, SPOT gapped down 13 points and has continued to drop another 8 points…after announcing an earnings miss of over 100%.
Now the stock owner only needs to be concerned with the directional reaction to the announcement. However, the option trader also needs to be concerned with implied volatility, and what is known as an IV crush the morning after the announcement. This deflating implied volatility will reduce the extrinsic value of an option’s premium regardless of whether the stock moves or not.
This means a directional options trader is at risk of taking a loss, even if the stock doesn’t move.
How can this be?
Unlike a stock price, which consists only of the intrinsic value of the stock at any given time, options are unique in not only that they have an expiration date, but that the time to expiration is monetized. So, traders are either buying or selling time, (extrinsic value), in addition to the intrinsic value of what the option has to be worth.
An option’s extrinsic value will inflate or deflate based on the implied volatility of the option either inflating or deflating. In the chart above, the green line under the candles represents the implied volatility of SPOT’s options in the six weeks leading up to today’s announcement.
An option’s implied volatility will usually inflate in advance of an earnings announcement, as IV is a measure of the expected magnitude of price movement. IV doesn’t measure direction, it’s neither bullish nor bearish. It measures the expected movement of a stock, (say in reaction to an earnings announcement), and is derived from the premium option buyers are willing to pay, and options sellers are willing to accept to take on their obligations when selling options.
There is no limit on how much an option’s premium can inflate prior to earnings, as while traders may know the date of the impending announcement, they don’t know what the announcement will be. And even if they knew what the earnings were in advance, no one knows the street’s reaction to those earnings.
However, the morning after the announcement, the unknown earnings announcement… is now known. And the future expectations go away, and the volatility will almost assuredly deflate.
In the below example, the little blue bulb represents Netflix’s earnings date, and you can clearly see the green implied volatility gauge inflating up to the announcement date, and immediately deflating the morning after the announcement.
Due to potential wide swings in an options volatility inflating or deflating, this is how an options trader can be right directionally, and still take a loss, or even take a loss if the stocks open flat. If you bought a call option because you were expecting a move up, and the stock opened flat, the option premium would deflate to less than what it was bought for, even though the stock didn’t go down.
Understanding supply and demand is of course very important in your success as a directional trader and establishing appropriate reward to risk parameters.
However, understanding volatility, and how it affects an option’s premium is of even more importance when overlaying options onto supply and demand…as an options trader can make a profit, or even a loss, without the stock moving, or moving in the right direction.
Trading options without understanding implied volatility is like driving your car and not understanding how weather conditions can affect the car.
Please make sure you learn the mechanics of options before trading them and have appropriate trading plans and rules for every trade.
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