Seeking Alpha
Short-term horizon, newsletter provider, ETF investing, option trading
Profile| Send Message|
( followers)

Apple (NASDAQ:AAPL) reported blowout quarterly earnings on July 19th and the stock had a huge gap up the following morning on the earnings report. AAPL shares opened up over 19 points higher, above 396 and closing in on the psychologically important $400 level.

However, this big move in this extremely popular stock is actually also a cautionary tale to option traders, especially novice ones. I was tracking some short-term AAPL options ahead of earnings as I anticipated that the big rally was likely to continue.

So last week, the day before earnings, the AAPL Weekly July 22nd expiration 400 Calls opened at 3.16 and traded up to 3.60 with the stock around 378. Then the next morning the stock gapped up 19 points, and those same 400 Calls opened at 2.43, traded up to 2.65 briefly and then plummeted to 0.60 cents, with the stock still up 11 points at 389.

This is a clear example of the risk involved when buying out-of-the-money (OTM) options that are purely comprised of premium in the price, a combination of time and volatility. Many novice option traders who were looking for a big move in AAPL ahead of earnings would be enticed by these "cheap" $3 calls at the key 400 strike. However the next day even after a huge move in the stock in their direction, the calls were down and quickly lost more value. They were dead on correct and still incurred more risk than reward.

Part of the reason this occurs is that around earnings/news announcements, the options of a stock will often price in the probability of a big move. Then after the announcement, the extra volatility priced into the options will often deflate like a balloon.

A couple of major factors are involved in why these options are more expensive ahead of a big announcement. Remember that the implied volatility (Vega) portion of option pricing is the only one controlled by humans (the other major Greeks are calculated in the formula and basically a function of implied volatility). The actual (historic) volatility of the underlying stock (and its options) is related to this number and is one of the main drivers of it, but implied volatility also takes into account deviations in volatility and in supply/demand.

Major news announcements are known for big potential moves in a stock. Ahead of a big earnings report, the various market makers in AAPL options are likely deluged by retail (and institutional) option purchasers. So what do they do as they are forced to sell more and more options to the public? They raise prices, which is seen in the time premium portion of the option pricing.

Basically, the time premium/volatility portion of option prices takes into account the likelihood of a big move in a stock like AAPL due to a earnings report and adjusts accordingly. Then after the earnings come out, often the excess premium comes out of the options.

Does this mean you should never buy options or Straddles ahead of earnings reports or major news announcements? No. But it's important to remember that the professionals (and their computers) who calculate the option prices are aware of the news event and the historical statistical probabilities.

This is why we generally prefer buying in-the-money (ITM) options with less time premium in them and higher Deltas. Let's take a look in this AAPL example above: Instead of the "cheaper" out-of-pocket OTM calls, take a look the tidy profits in the deep ITM options - the AAPL July 370 calls opened at 14.65 the day before earnings, opened at 26.55 after earnings, and then were 18.85 with the stock at 389ish.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.