Volatility crush around earnings

In short

A friend of mine once bought a call option the afternoon before earnings. The company reported good news, the stock rose, and he still lost money. You may have felt that sting yourself, or you may be trying to avoid it. The cause has a name, volatility crush. Before an earnings report, option prices carry extra cost for the uncertainty ahead. Once the news is out, that extra cost drains away, often within minutes of the open. A reader can look up the implied volatility of an option and compare it to what the stock has really been moving. The price of the straddle also shows what size move the market already expects, and the stock has to beat that figure for a buyer to come out ahead. Seeing this ahead of time costs nothing.

The whole of it

What it is

I once watched a neighbor wait out a thunderstorm on his porch, and he told me the waiting was worse than the storm. Option prices work a bit like that. The wait for earnings makes people nervous, and nervous people pay extra for protection.

Implied volatility is the market's guess at how much a stock will swing, folded into the price of its options. When a big event sits on the calendar, the guess goes up. Earnings reports are the classic case, since a single announcement can move a stock a lot in one night. Higher implied volatility means higher option prices, for calls and puts alike.

Volatility crush is what happens when the event passes. The uncertainty is gone, so the extra cost is gone too. Implied volatility falls, sometimes sharply, and option prices fall with it. Nothing about the company has to go wrong. The storm simply ended.

How it works

If you hold an option, you have probably noticed that its price depends on more than the stock. The Options Clearing Corporation and the Cboe both publish education on this, and the short version is that an option price has two parts. One part is intrinsic value, which is how far the option is already in the money. The other part is time value, which is what buyers pay for the chance that things change before expiration. Implied volatility drives much of the time value.

Before earnings, time value swells because the possible range of outcomes is wide. After earnings, the range narrows. The stock has landed somewhere, and the market no longer needs to price a big unknown. So time value shrinks, even if the expiration date is still weeks away.

Here is the part that trips people up. The option price can fall from the crush while the stock price moves in the holder's favor. Two forces pull in opposite directions, and the crush can win. That is how my friend lost money on good news. His call gained from the stock rise, but it lost more from the drop in implied volatility.

The market also shows how big a move it expects. A rough guide is the price of an at the money straddle, which is one call and one put at the same strike, both expiring just after the report. If that straddle costs $6.00 on a stock trading at $100, the market is pricing about a 6 percent move. A buyer of that straddle needs a bigger move than that to profit. It is plain arithmetic.

The numbers, and where to find yours

Your own numbers sit in your brokerage's option chain. Look for a column labeled implied volatility, often shortened to IV. Compare the IV of the expiration just after earnings to the IV of an expiration a month or two later. The gap between them is a hint of how much the market has loaded into the near date.

Some brokers also show IV rank or IV percentile, which tells you where today's IV sits against the past year of the same stock. Brokers may calculate these in their own ways, so read the help page for the one you use. The Cboe also publishes the VIX, which measures expected volatility for the S&P 500 as a whole. It will not tell you what is happening in a single company's options.

For the expected move, add up the price of the at the money call and the at the money put for the first expiration after the report. Divide by the stock price. That is the rough percent move. For a stock at $50 with a $1.50 call and a $1.40 put, the sum is $2.90, and $2.90 divided by $50 is 0.058, or about 5.8 percent.

If a person sells options rather than buys them, one more thing matters. The broker sets margin and approval levels, and the rules for those come from the broker and from FINRA. The broker can say what a given account allows. None of this is a reason to trade. It is only a way to read the board.

A worked example

Let me tell you about a woman named Dana. She follows a company whose stock sits at $80 the day before earnings. She likes the business and thinks the report will be good. She buys one call option, which covers 100 shares, with a strike of $80 and an expiration three days after the report. The option costs $4.00 a share, so she pays $4.00 times 100 shares, which is $400.

That $4.00 is all time value, since the option is right at the money and has no intrinsic value yet. The implied volatility on that option is high because of the report.

The company reports good news. The stock opens at $82, up $2. Dana feels pleased for about one minute. Then she checks her option. Implied volatility has dropped, and the call now trades at $3.40 a share. At $3.40 times 100 shares, her option is worth $340.

She paid $400 and now holds $340, so she is down $60, even though the stock rose $2. Let us check the pieces. At a stock price of $82 and a strike of $80, the option has $2.00 of intrinsic value. That means the remaining $1.40 is time value, because $3.40 minus $2.00 is $1.40. Before the report, all $4.00 was time value. So the time value fell by $2.60, since $4.00 minus $1.40 is $2.60. Her gain from the stock move was $2.00, and her loss from the crush was $2.60. The net is $2.00 minus $2.60, which is negative $0.60 a share. Over 100 shares, that is a loss of $60.

Dana was right about the company and still lost. She was not foolish. She was missing one piece of the picture, and now she has it.

Take a different path for a moment. Say the stock had climbed to $86 and the same crush had left $1.40 of time value. The intrinsic value would be $6.00, so the call would trade at $6.00 plus $1.40, or $7.40 a share. That is $740 on 100 shares, against her $400 cost. The size of the move is what changes the outcome. In the real story, the move was too small.

Where it goes wrong

I have made my share of mistakes, and the common ones here are easy to spot after the fact. The biggest is treating an option as a simple bet on direction. It is a bet on direction, size, and timing all at once, and the price of implied volatility is baked in at the start.

Another mistake is buying the option with the shortest expiration because it looks cheap. It may be cheap in dollars, but it can be expensive in terms of the move the stock must make. A low price tag does not mean a fair price.

Some people try the opposite and sell options before earnings to collect the rich premium. That carries real risk. The seller of an option must stand ready to deliver on it, and a surprise move can cost far more than the premium collected. The seller has to cover that loss, and the loss on a short call has no fixed ceiling. Broker approval rules exist for a reason.

A smaller trap is forgetting that the crush can happen even when the stock does not move at all. If the stock sits flat, the buyer loses the time value and gets nothing back. Also remember that after the open, quotes can be wide and fills can be poor, so the price on the screen is not always the price paid.

Last, one past quarter says little about the next. A stock that moved 8 percent last time may move 2 percent this time. Past swings are a clue, not a contract.

Questions to answer before you leave this page

Have you looked at the implied volatility of the option you are eyeing, and compared it to a later expiration on the same stock? Do you know the size of the move the straddle is pricing, and can you say in plain words how far the stock must go to reach break even? If the stock rises but implied volatility falls, are you ready to see a loss anyway? Would you be comfortable losing the full price of the option, since that is the most a buyer can lose? If you are thinking of selling instead, do you understand what the seller must cover if the stock jumps, and does your broker approve that kind of trade for the account? And have you read the education pages from the Options Clearing Corporation and the Cboe, so that the words on your screen match the ideas in your head?