A few weeks ago, I mentioned discovering that archived Options 101 articles go all the way back to 1998. I had taken a fresh look at some of the precepts from that earliest archived article, "Top Ten Rules for Option Trading." The second in that list began with the admonition, "Never hold a position over an earnings report." That was an admonition that I heard repeated frequently when I first subscribed to Option Investor, before I began writing for the site in 2002.

The reason that Option Investor has always cautioned not to hold option trades over an earnings announcement has to do with what happens to option prices before an earnings announcement. They tend to get plumped up. Implied volatilities, one of the inputs into an option's price, tend to get pushed higher before the earnings. Once the earnings results are known, those volatilities collapse. Both market forces--traders buying options ahead of earnings and market makers pricing in the probable movement of the stock after earning--combine to increase those implied volatilities before earnings.

Therefore, when I was reading Jeff Augen's The Option Trader's Workbook: A Problem-Solving Approach and came to Augen's question on page 29 of his workbook, I knew the answer immediately. Augen's asked his readers if they could "think of a . . . scenario in which the stock price falls rapidly and puts also lose value?"

Such a scenario could of course happen after earnings were released. Let's look at an example. On December 3, with GIS at 68.19, the nearest strike puts and calls were the 70's. DEC and JAN calls and puts at that strike displayed the following prices and volatilities.

GIS 70-Strike Calls and Puts, DEC and JAN:

At the close on December 16, the day before GIS's before-the-open earnings release, volatilities had increased. However, time had also taken its toll on those same options.

GIS 70-Strike Calls and Puts, DEC and JAN:

Was it safe to buy a long straddle in either the DEC or JAN options? The cost of the DEC straddle was $1.45 plus commissions and the JAN, $3.23 plus commissions.

At the open on December 17, after GIS's before-the-market report, many equities dropped, but GIS was bucking the trend. It had closed at $68.29 the previous day, but soon hit an early market high of $69.93. However, look what was happening with prices and with volatilities in the screenshot below, captured near that early morning high, at $69.29. Although that screenshot wasn't captured at the exact high of the morning, GIS pulled back rather sharply from that high, and this capture was probably a realistic estimate of where a trader would have been able to get an order in and exit.

GIS 70-Strike Calls and Puts, DEC and JAN:

The DEC straddle was then worth $1.03 and the JAN, $3.13. Other than the JAN 70 call, implied volatility had dropped in all options pictured, with the drop especially hard in the DEC options, despite GIS's sharp climb off Wednesday's close.

By mid-morning, when GIS had dropped back to $68.90, slightly increasing implied volatilities and higher values in the puts pushed the DEC straddle's value up to $1.26 and the JAN's, to $3.16, but both were still below the value at Wednesday's close.

What's the lesson? By December 3, GIS's implied volatilities were probably already inflated above historical volatilities. They certainly were by Wednesday, DEC 16, the day before GIS's earnings announcement. In fact, one charting source shows that GIS's implied volatilities began diverging from the trending-lower 30-day historical volatilities as early as the first week in November.

That time period might be different for different underlyings, depending on their historical behavior after earnings, but the general idea is the same. Implied volatilities--and, therefore, option prices--tend to get inflated before an earnings report, but implied volatilities tend to collapse rather quickly after the report, making it more difficult for an option trader to benefit from a price movement immediately after earnings. Even call buyers might have been disappointed by the values in their options as GIS was climbing sharply that Thursday morning after earnings, and straddle buyers certainly would have been.

So, although GIS's immediate reaction after earnings was a sharp climb, the information provided above still allows for an answer to Augen's question. Yes, we can visualize a situation in which puts don't benefit from a drop in price, and that situation is the immediate period after an earnings report. Augen warns, "The distortion [in implied volatilities] is especially large when an earnings release coincides with options expiration," as GIS's did. "For those stocks," Augen adds, "implied volatility rises sharply to offset the rapid time decay of the final few days of the expiration cycle." Just as the Option Investor staff writer did back in 1998 and as our own observations have proven, the implied volatilities quickly revert back to normal after earnings.

If you're tempted to buy a straddle just before earnings, you have to feel fairly certain that the stock is going to move far more than is typical for that particular stock after earnings. You have to believe that you're smarter than the market makers who have already priced in the typical movement for that stock after earnings.