Doc Maher wraps up the discussion.
In my last post I discussed the trading environment leading up to Google's earnings announcement. Well now that the earnings have come out, let's look at our hypothetical straddle that we put on before the news. First let me explain that I expected this to lose money and so I suspect did many market makers who were pricing the options. I'll explain this later on but first let's see what did happen.
Below is a chart of GOOG prices starting at 4/17's open. We can see that on 4/17 GOOG closed at $449.54 which is why I picked the 450 Puts and Calls for my straddle. Today however we can see that GOOG opened up at $498 and kept climbing all day to close at $539 a gain of about $90.
Click here for a larger chart.
This was of course due to a good earnings report which came out last night. The straddle was designed to make money on movement either way so let's look at what it looked like last night when we created the example.
Click here for a larger P+L graph.
With a move of almost $90 we would have expected the trade to make approximately $4000. Note what the IV's for each option was last night, 49.58 and 47.22. The cost of the straddle was $26 for the Call and $24.40 for the Put for a total of $50.40 ($5,040 because there 100 shares per contract).
Well here's what the P&L looked like at the end of 4/18.
Click here for a larger P+L graph.
OK so it actually would have made over $4,000, but I said I expected it to lose. Why? Well, look at the break even prices on the right. GOOG needed to go higher than $482.22 or lower than $410.95 from its 4/17 price of $449.54 which is about $35 dollars either way and GOOG hasn't been moving that much on earnings lately.
But wait a minute last night when we looked at it the straddle looked like it would make money on any move. The P&L is below:
Click here for a larger P+L graph.
See it looked like it couldn't lose on a move. So why does it look different today? It's the IV drop. Today there are losing positions between $482.22 and $410.95 because the IVs dropped from 49.58 and 47.22 on 4/17 to 40.80 and 39.25. This is what causes the dip in 4/18's P&L versus 4/17's. Why did the IV drop? It's because the news (earnings) is over and so is the speculation. Instead of strong buying just before the news we now have everyone wanting to sell back to the market makers and that makes the price drop.
I'm simplifying here but this will give you the idea. When the Market Makers are pricing options they are estimating how much the stock will move knowing that they will drop the IV after the news is out. So in this case it looks like they were expecting that GOOG would not move more than $35 up or down and they priced that move into the options. If GOOG had stayed in that range the market makers would have made the money. However because GOOG greatly exceeded the expected or "priced in" move there is probably much gnashing of teeth on the floor today. Here is what they expected to see today. It's the same P&L graph, I just zoomed in so you can see the impact of the IV falling. If GOOG had not moved as much as it did the IV may have fallen even further and this would have looked even worse.
Click here for a larger P+L graph.
Notice that when it opened at $498 this straddle was barely in the green. In fact I was watching this and right at the open and it actually opened at about $82.50. So it was making money right away. Because of the big jump in price the IV crush was not a factor. Two reasons for this first the 450 options were so far from the price that there was very little time values left in them anyway. Second the IV didn't drop as much as one might expect because the big price jump didn't result in a lot of selling back to the market makers, it generated interest and helped hold the prices up a little. Check out the IV chart:
Click here for a larger Volatility graph.
I'll zoom in so you can see it better.
Click here for a larger Volatility graph.
This example was expected to show how you can get crushed by using a straddle just before earnings when the IV is high then finding out that the IV has dropped over night. However this time we got a "surprise" move that overcame the IV crush.
Ok I wasn't the only one that was surprised. In any case, I hope that you learned something from this and I'll be posting more on this topic of gaining (or losing) from IV moves. For now I hope this example doesn't confuse anyone too much.
"Income Trader"
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This comment and any market data included here were prepared on 4/21/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
