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

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.

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?

I sold some Priceline straddles today.

The Event

They are announcing earnings next Tuesday which makes the implied volatility high, around double the historical volatility.  I sold the options far enough away from where the stock is trading that I am protected from moves up to three or four standard deviations of one day price moves.  I also have time decay working for me.

It looks like a good trade.

We’ll see.

Time Decay

We’re going into a long weekend and next week is expiration week.  From the end of the trading day today, until options expire next Saturday at 5 PM, is 192.5 hours.  It is noon now in New York, so there are four and a half more trading hours left to Friday.  Then there is the rest of Friday night, seven and one half hours. Saturday, Sunday, and Monday is 72 hours.  So from the end of trading today there is 79.5 hours of weekend and nine and one half hours until the market opens Tuesday.  That gives us 89 hours out of the remaining 192.5, really we shouldn’t count the Saturday that options expire, since there is no trading on Saturday.  So that would give us only 168 hours until the end of trading Friday.  For 89 out of those 168 hours there is no trading.  That is a little more than half the time remaining.

But options are decaying as the clock is ticking.

Weekend Volatility

Volatility doesn’t go away completely over the weekends.  Remember the weekends last Fall when the Federal Reserve or the Treasury had a new plan to announce every Sunday.  That led to gap openings on Monday morning.  Typically, the volatility over the weekend is less than one half the weekday volatility.

Today is a good day to sell February series options.