Google announces first quarter earnings this Thursday, 16th of April, after the markets close. The next day, Friday, is the last day to trade April options. In the past few years, Google has announced second quarter earnings on the Thursday before expiration of the July series of options and third quarter earnings on the Thursday before expiration of the October series of options. The fourth quarter earnings are announced at the end of January breaking the pattern.
Implied Volatility
Earnings announcements are important events for a company’s stock. In fact, if you believe the efficient markets hypothesis, stock prices shouldn’t move at all unless there is a new piece of information about future earnings of the company. Yet, we see stock prices fluctuating all the time.
Because of the uncertainty surrounding the earnings to be announced, the implied volatility of the options increases throughout the week. Last week, Google April options were trading at an implied volatility of 60%. Later option swere trading at 40%. This morning, the implied volatility of April 370 options was 85%. This increase in implied volatility makes the options more expensive.
Fighting this increase in option price is the time decay to option expiration. Each day the options lose value because the clock is ticking, this is measured by theta. The theta for the at the money options is approximately -$152. Each day, the option loses $152 in value. How much does the implied volatility have to rise to compensate for that? The vega for the same option is 17.2. That means that for every one percent increase in implied volatility, the option will increase in value by $17.2. So each day implied volatility of the options have to increase by 8.8% just to compensate for the time decay.
Past Earnings – Expiration Weeks
| Option Series | Mon | Tues | Wed | Thurs | Change |
| Oct 2006 | 70% | 80% | 95% | 125% | 55% |
| Apr 2007 | 55% | 63% | 78% | 110% | 55% |
| July 2007 | 58% | 63% | 86% | 110% | 52% |
| Oct 2007 | 72% | 76% | 91% | 115% | 43% |
| Apr 2008 | 81% | 90% | 110% | 150% | 69% |
| July 2008 | 92% | 101% | 122% | 173% | 81% |
The last column shows the change in implied volatility from Monday to Thursday. (I don’t have access to data for the October2008 series). If the decline in value of the option due to time decay is 9% per day, does it make sense to buy a straddle and wait for the value to increase until earnings are announced?
Here is how a near the money straddle evolved over the same week as in the table above.
| Option Series | Mon | Tues | Wed | Thurs | Change |
| Oct 2006 | 24.55 | 24.4 | 23.65 | 22.75 | -1.8 |
| Apr 2007 | 21.9 | 21.8 | 22.55 | 21.65 | -0.25 |
| July 2007 | 26.55 | 25.45 | 28 | 25.45 | -1.1 |
| Oct 2007 | 37.5 | 34.3 | 35.7 | 34.7 | -2.8 |
| Apr 2008 | 31.45 | 31.25 | 29.35 | 29.4 | -2.05 |
| July 2008 | 41.05 | 40.05 | 38.8 | 38.8 | -2.25 |
So the increase in volatility does not compensate for the time decay.
This raises further questions. Since most of the time decay takes place overnight, does it make sense to buy the straddles as a day trade?
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