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"Why Did My Call Options Fail To Profit During Earnings Release?"

Question By Greg

"Why Did My Call Options Fail To Profit During Earnings Release?"

Question: Why is it that I bought an call options on Apple a day before it reported earnings and it gapped up overnight from $121 to $125 but the option price had not gotten much bigger from the day before? A move of $4 in the underlying I would think would push the option price alot higher than it did. Expiration was about 24 days out. Theta could not have killed me. This is really frustrating. Do Market Makers manipulate the option prices each day to their liking? What should I be aware of. I buy before earnings sometimes? Volatility? Thanks. Greg.

Asked on 25 April 2009

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Answered by Mr. OppiE

Hi Greg,

Buying call options before earnings release has always been the most frustrating experience for most beginners to options trading, so I totally understand your feelings because I have been there myself.

In order to understand what happened, you need to first understand 2 things; Major price determinant of stock options and characteristic behavior of stock options running up to earnings release.

The price of stock options are made up of two parts; Intrinsic Value and Extrinsic Value. Intrinsic value is the amount of built in value of a stock option and is determined by how much in the money the option is. Extrinsic value, or Time Value, is the value of the stock option that you pay to whoever is selling those option to you. Intrinsic value and extrinsic value are two things every options traders should know before proceeding into options traidng. Now, intrinsic value is pretty straight forward. It is the extrinsic value that is tricky. There are four main elements that go into calculating the extrinsic value of a stock option; Interest Rate, Time to Expiration, Implied Volatility and Dividends. Of these elements, the most influential are the Time to Expiration and the Implied Volatility. Time to Expiration is pretty straight forward and your question revealed that you know about time decay and the theta effect in options trading. And you are right, it has nothing to do with theta. It is the Implied Volatility part that you may have overlooked.

The implied volatility of a stock is its expected movement over the next 30 days. The more the stock is expected to move in a big way, the higher the implied volatility. The higher the implied volatility, the higher the extrinsic value of its stock options become.

With that in mind, lets examine the characteristic behavior of stock options running up to earnings releases.

During the few days before a company's earnings release, speculators (such as yourself) rush in to take positions in order to "take advantage of the expected explosive move". This causes a sharp increase in implied volatility which drives the extrinsic value of stock options up, especially on the out of the money options. As the earnings release date draws nearer, implied volatility gets higher and PEAKS on the day just before earnings release... which sadly, was the day you entered your trade. The day before earnings release is when the extrinsic value of short term options are the highest. In fact, as analysts, we usually look at the amount of extrinsic value as a percentage of the stock price in order to estimate how much the stock will move. For instance, DNDN's call options in April, just before it suddenly shot up was about 25% of the price of the stock. This gave analysts such as myself the first indication that the stock might go up by about 25% very soon. Indeed, less than a month later, DNDN shot up by about 25% and then moved up from there, never looking back. (exact figures not provided here)

What this means is that the extrinsic value of stock options before any explosive move in a stock usually full prices in the most probable move of that stock. Now, if you buy an option like that, you will experience what is known as a Volatility Crunch in options trading on the earnings release day itself. Volatility Crunch is like a volcano erupting. The volcano has built up into a huge extrinsic value running up to the day before earnings release and then erupts with the stock, evaporating instantly as the stock makes its move. In fact, such a move usually takes up almost all of the extrinsic value of the option if the move puts it sufficiently in the money. If the stock moves up by $4 and evaporates $4 worth of extrinsic value in the option, would you make any money? Of course not.

As professional traders, we have a myriad of ways to make money from earnings release using options and the most common techniques are to buy the options a couple of weeks before earnings release and then sell it the day before earnings release in order to reap the high extrinsic value as profit or we buy the stock and SELL the out of the money options so that even if the stock does not move that much, we benefit from the high extrinsic value sold. An even safer way is to put on a delta neutral position with positive vega a couple of weeks before earnings release in order to benefit directly from implied volatility.

In conclusion, market markers are the ones who price options but it is not a deliberate scheme to reap investors off with high extrinsic value just before earnings release. The high extrinsic value is justified by the sheer volume and demand of speculators going into the stock, just like anything else in the world. High demand = high price.

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