It Happens Every Quarter
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 ìbeastsî. These ìinstructiveî stories have various iterations, but one frequently repeated story has a core point of ìwisdomî 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 ìobviousî conclusion? The market makers are thieves, the options game is rigged, and I need to look elsewhere for trading opportunities.
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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 traderís 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.
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About Dan Passarelli
Dan Passarelli, is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLC. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.
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