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Trader's Corner

What Are You Implying?

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Micron Technology (MU) was due to report Tuesday, October 2. Since dropping to a summer low of $10.30 on August 16, MU had mostly traded in a $1.50 range, but you expected more movement after earnings.

Why? For one reason, the SOX had been trading in a triangle during that same period, and that triangle was narrowing to its apex. It had to break some direction or other soon, and you figured MU's earnings might just be the impetus that would break it. MU was rising just under its 50-sma, and earnings might either break prices above it or roll them down under it.

MU didn't announce the time of day when earnings would be released on Tuesday. It could have been before the market opened, after it closed or any time in between. You decided to buy an ATM straddle sometime Monday, October 1 to take advantage of the price movement you expected. The ATM front-month (October) options were cheap, under a dollar each, so you wouldn't be spending much per straddle contract.

October Options Chain for MU, from CBOE.com:

Although it might be difficult to discern from this snapped image, it looks as if shortly before noon on Monday, October 1, with MU at $11.28, purchasing an Oct 11 call and put would have cost you about $105.00. I'm being conservative in the estimate here, not splitting the bid/ask down the middle but rather shaving only a nickel off the ask for the combined position. Perhaps an astute trader could have gotten into the straddle for a little less.

You think MU should move big enough either direction to give you a profit on the combined position. You sit back, satisfied. This was a good idea, right, this potential earnings play? Maybe.

Maybe not.

You're leaving out something. Two somethings, actually, including a consideration of whether you should have bought front-month or back-month options. The consideration this article addresses is a different one, however. What are the implied and historical volatilities on this day before earnings? Are they far apart? If so, and if the implied volatility reverts to a value closer to the historical volatility after earnings are released, what's going to happen to your straddle?

Before we go further, it's time to talk about historical and implied volatility. Historical volatility is determined by measuring how much an underlying has moved, its actual trading history, over a period of time. According to the great Larry McMillan in his book, TRADING OPTIONS AS A STRATEGIC INVESTMENT, it is "[g]enerally measured by the annual standard deviation of the daily price changes" in the underlying. According to Dan Passarelli, a presenter of CBOE webinars, it's "the annualized standard deviation of daily returns," just a different way of saying the same thing. In other words, it's based on a mathematical manipulation of past actions of the stock.

You don't have to understand how to calculate it. You do need to have these general understandings: it's based on the actual movements of a stock, index or other underlying; it's based on what happened in the past; and underlyings with higher historical volatilities tend to move around a lot more than underlyings with low historical volatilities.

On October 2, my broker listed MO's historical volatility at 13.24 and FFIV's at 46.27. Logic tells you that MO's daily chart would be the one dotted with a bunch of small-bodied daily candles while FFIV's would be dashed with larger-bodied green and red candles. FFIV has, over the last year, proven more volatile than MO.

Implied volatility isn't based on anything that's happened in the past. McMillan terms it a prediction of where the stock price might go, with that prediction based on option prices at any one time. Passarelli calls it the market's consensus of volatility in the future. It's the value that's used in the option pricing model to give a theoretical price for an option. If you've never seen one, options pricing calculators such as the one on ivolatility.com require inputs that include a value for implied volatility.

You can go both ways with the calculator. If you know the price of an option, you can figure out what the implied volatility is. If you want to figure out a theoretical value for an option if the implied volatility were to move to a certain level, you can input that implied volatility and crank out a theoretical value for the option. Of course, the calculators require other inputs, but this is the one that concerns us with this article.

Because historical volatility measures actual movements of the stock and is based on those movements, and implied volatility provides an estimate of future stock action and is based on options prices (or, conversely, determines them), implied volatility sometimes moves far above or below historical volatility. Some traders believe that implied volatility will eventually revert to the mean, or move back closer to historical volatility.

That's the background, a brief refresher on historical and implied volatilities. At the same time the first chart on MU was snapped, my broker pegged MU's historical volatility at 35.29, with the historical volatility drifting down into earnings, as sometimes happens. Traders often don't want to take new stock positions just before earnings, so the historical volatility drifts down. Instead, they may be buying and selling options, either to hedge their stock positions or to engage in a speculative straddle of the type you've just entered in this hypothetical case. Implied volatility tends to go up before earnings as traders buy options, speculating that the stock may move after earnings.

Here's the chart Brokersxpress displayed on October 1, at about noon.

MU's 12-Month Volatility Chart:

Again, it may be difficult to discern from this chart, but the implied volatility stood at about 43. What would happen, then if MU's stock price moved but that IV reverted to the historical volatility's value, dropping into the mid 30's?

Brokersxpress includes a "pricer" function that lets traders calculate just such changes. Let's imagine that by Thursday, October 3, MU had moved up to 13.00, but the IV had dropped to 35.50, closer to the historical value. The pricer returns the following values:

OCT 11.00 Call theoretical value: $2.03
OCT 11.00 Put theoretical value: $0.00

That's pretty good. You'd make money, although may not as much as you'd hoped, particularly after you paid commissions to open and close the position.

What if MU climbed only to $12.00?

OCT 11.00 Call theoretical value: $1.07
OCT 11.00 Put theoretical value: $0.05

Uh, oh. You admit that the gains in stock price haven't been big, but maybe that's still not quite the result you hoped to see, given that you're going to have to pay commissions both ways, to establish the straddle and to sell it to close. You have to consider, too, that this is the optimal pricing, and that the market maker is going to probably want to pay you less than that. MU has moved but you haven't benefited.

What if MU dropped to $10.00?

OCT 11.00 Call theoretical value: $0.04
OCT 11.00 Put theoretical value: $1.02

Again, that's far from what you expected, with MU theoretically dropping $1.28 from the price you'd paid two days earlier, before earnings. This, too, is the optimal, theoretical price, which you're probably not going to be able to get when you sell the straddle, and it's only about a penny above the price you paid for the straddle without even considering all those commissions.

Obviously, with both time decay and a declining implied volatility working against you, you're going to need a big percentage move in MU to benefit from that straddle. A cheap strategy might not equate to a good one.

So what actually happened? A sell-the-numbers reaction occurred. Shortly before 1:00 EST on October 3, MU was at $10.60, $1.19 below the previous day's close and $0.68 below the level at which you purchased the straddle. So, there was some movement, albeit slight, but you already know from the calculations above that the action might not be good for your straddle. The news was going to be worse than anticipated, though.

October Options Chain Snapped at 12:50 on October 3:

From this chain, we can see that the OCT 11 call was $0.15 x $0.20 and the put, $0.55 x $0.60. Lucky traders might be able to sell that straddle for $75.00 ($0.75 combined for the call and put x 100 multiplier), but many will recoup only $70.00 of their original $105 cost. Commissions would need to be paid both directions, too.

Not so good. Obviously, the implied volatility had dropped closer to the historical volatility. You were the victim of a reversion to the mean on implied volatility.

Perhaps as you study other reporting periods, you also notice something that I did: although MU sometimes moves big after an earnings report, sometimes it doesn't. Maybe one could conclude ahead of time that a pre-earnings straddle wouldn't be a great tactic for MU, no matter how cheap the strategy.

The lesson? Before you jump into a straddle the day before an earnings report, the outcome of an FDA application or the release of an important new product, check to see whether implied volatility has jumped way above historical volatility. Check to see whether the stock or index's price movements after such events have been large enough to overcome the deleterious effect on options prices when implied volatility reverts to a level closer to historical volatility. Otherwise, you might be throwing away the money you spent on that cheap straddle. You might find that a different options strategy would serve you better.

Just a note: In case you were thinking that holding out a bit longer might have worked, MU was last trading at $10.80 as this report was edited on Friday afternoon. The OCT 11 call was 0.20 x 0.25, and the put, $0.40 x 0.45. The straddle wouldn't have benefited from waiting.

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