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July 24, 2014

Earnings Season and Option Prices

With earnings season in full gear and major players like LinkedIn and Tesla ready to announce soon, it is probably a good time to review how an option price can be influenced.

Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 6, 2011

Analyzing Options With Volume and Open Interest

Volume and open interest are two very important options data that can help traders understand what is going on in the options market. it is an important part of any trader’s options education. Volume and open interest helps traders make better decisions, and can make them more profitable traders. But to be able to use volume and open interest data, traders must understand exactly what each represents. Let’s take a close look at volume and open interest.

Volume and Open Interest

Volume and open interest are two distinctly different things. Volume is the number of contracts traded in a day. Each day volume starts over at zero. Open interest is the number of contracts that have been created—that are open. Open interest is an on-going, running total.

Volume and Open interest Example

Imagine it is the day after expiration and a new contract month, the November expiration cycle, is listed for option class XYZ. A trader, Retail Joe, logs into his online retail trading account from home. Retail Joe enters a buy order to buy 10 November 65 calls. The order is routed to the exchange and executes with Mark Etmaker, a market maker on one of the U.S. options exchanges.

Because this is the first day these contracts were made available to trade, open interest was zero at the start of the day. Volume is always zero at the start of the day. After the trade is made, both open interest and volume increased: Retail Joe is long 10, and on the other side of the trade, Mark Etmaker is short 10. Therefore:

Volume: 10

Open interest: 10

Now imagine that later that day, a third party trades in the November 65 call series. Tina Trader decides to sell 10 calls (maybe as part of a covered call). It just so happens that Mark Etmaker is the market maker who buys the calls from Tina. Notice what happens with volume and open interest.

Volume: 20

Open interest: 10

Because the trade happened the same day, the trade increases volume by the number of contracts traded. But a new contract wasn’t created; it just changed hands. Now, the two parties to the call are Joe and Tina; Mark Etmaker is flat. Therefore, open interest remains the same.

The next morning, volume and open interest is:

Volume: 0

Open interest: 10

Volume starts anew and open interest continues on.

Now, imagine that (coincidentally) Joe decides to sell the 10-lot to close and Tina just so happens to buy hers back at the same time; they trade with each other. Now, both Joe and Tina have no calls—they are flat. Now volume and open interest is:

Volume: 10

Open interest: 0

Ten contracts changed hands; so volume is 10. And the existing contract was closed; so open interest is zero.