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October 25, 2010

It Happens Every Quarter

Classic parables of warning are often offered to traders considering exploring the world of option trading by those who do not understand the physiology of the various option “beasts”. These “instructive” stories have various iterations, but one frequently repeated story has a core point of “wisdom” that can be illustrated by the following frequently encountered sequence of events: A trader buys call options shortly ahead of correctly predicting better than expected earnings and the expected price rise of the underlying. When the options open following this increase in price of the underlying, he has gained little if any profit from his long call. The “obvious” conclusion? The market makers are thieves, the options game is rigged, and I need to look elsewhere for trading opportunities.

Perhaps we should not throw the baby out with the bath water quite yet. Is there some rational explanation for this behavior? In a word, yes, there is. In order to understand the phenomenon, we need to consider the physiology of an option.

One of the major determinants of the magnitude of the option time premium (aka extrinsic premium) is the implied volatility (IV). There are various available databases available to track the history of this value, and a reproducibly observed phenomenon is that IV almost always stereotypically correlated with earnings releases. It typically spikes in anticipation of the release and the uncertainty surrounding this information and collapses very quickly following the release and the resultant price reaction of the underlying to this information.

It is this rapid, predictable decline in IV that results in the commonly observed sequence of events related in our parable. If the purchased option contained significant time premium, it will have been devastated by the collapse of IV and the trader’s anticipated profits will have been erased or significantly reduced.

Armed with this knowledge, is there any way to immunize the trade against this sequence of events? As you may have guessed, the answer is yes. While description of the various strategies is beyond the scope of this brief post, suffice it to say that the category of vega negative or vega neutral trades holds the key to dealing successfully with this situation.

Bill Burton, Market Taker Mentoring LLC