I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Tuesday, November 6, 2007

Example On How Implied Volatility (IV) Affects Option’s Price Significantly

As discussed earlier, in options trading, Implied Volatility (IV) has a considerable impact on an option’s price. An option’s price can go up or down due to changes in IV, although there is no change in the stock price. Some times, for instance, we also find a stock price has increased, yet the Call option of the stock did not increased, but it dropped instead.
Now, let’s see a simple example on how IV affects an option’s price considerably.

In the prior post, it’s shown that IV will normally begin to rise starting from a few weeks before the announcement day. And once the announcement is out, the IV will drop significantly.

The fact that the IV will drop considerably right after the announcement is extremely important to note, particularly when you’re trading options by buying straight call / put options (directional play) or buying strangle / straddle (non-directional play) over earnings announcement.
This is typically the reason why you might see that the stock price has gapped up / down in your direction, but yet the option’s prices do not move profitably.
Why is it so?
Remember that, for both Call & Put options, an increase in IV will increase an option’s price, whereas a decrease in IV would decrease an option’s price.
(You may want to refer to the posts on Vega or Options Pricing for further discussion).

The increase in IV before the earnings announcement is to “anticipate” the volatility as a result of the announcement. In other words, certain magnitude of the price movement (either up or down) has been “priced in” by the increase in IV, which causes the option’s price to be more “expensive” than normal.
Once the announcement is out, the IV will drop significantly, which would affect the option’s price negatively.

Therefore, to be profitable in such cases, the increase / decrease in stock price must be big enough to offset the negative impact of the drop in IV on option’s prices.
And for strangle / straddle, the stock price movement must be even much bigger in order to offset both the drop on option’s prices at both legs (call & put legs) due to the drop in IV as well as the drop on option’s price at the other leg after the stock price moves to certain direction.

Therefore, in this case, it’s important to first assess the Reward / Risk ratio of a potential trade by inputting different scenarios of IVs and expected / target stock prices (using Options Calculator / Pricer).
By doing this, you can anticipate what your best & worst scenarios are, have your risk & return calculated, and determine if the trade is worth taking.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

Related Topics:
* FREE Trading Videos from Famous Trading Gurus
* Options Trading Basic – Part 2
* Option Greeks

5 comments:

Tony Chai said...

Hi OTB :

As usual, nice article. You're right to point out the need to assess the risks rewards ratio before taking up a trade.

Stocks like SCHN, GRMN, CROX, AMZN went up a lot in last quarter earnings thus in this quarter the options were more expensive because the previous gapping magnitude were priced into the options this round.

But most of these stocks tanked this quarter's earnings due to higher expectations from the market.

I've ever mentioned in my blog about stock price could possibly tank if high expectations were anticipated but the company only manage to report marginal earnings results.

So do be careful.

Yours Truly,

Tony Chai
My Options Trading Blog

OPTIONS TRADING BEGINNER said...

Hi Tony,

Thanks again for your inputs.

I believe your experiences are very valuable to many of us.
Thanks a lot for sharing them.
I really appreciate it. :)

Best Regards,
Options Trading Beginner

jchang5069 said...

Dear OTB:

Good advise. Please advise where I can get more information about
assessing the Reward / Risk ratio of a potential trade by inputting different scenarios of IVs and expected / target stock prices (using Options Calculator / Pricer). Thanks.

jchang5069 said...

Dear OTB:

Please advise where I can read more to assess the Reward / Risk ratio of a potential trade by inputting different scenarios of IVs and expected / target stock prices (using Options Calculator / Pricer). Thanks

OPTIONS TRADING BEGINNER said...

Hi jchang,

I'm not sure where you can read more or find examples on how to calculate Reward/Risk ratio using Options Calculator.

But probably one day I’ll try to make a post about that.

Basically, to get the “Reward” and “Risk” here, you should input your potential target stock price and the initial stop loss, respectively, in the “Stock Price” variable for Options Calculator / Pricer to get the estimated option prices for your “Reward” as well as “Risk”.

By inputting different scenarios of IVs, you can have some expectation on what will happen, for instance, when the stock price actually hit your target while the IV remains / increases / decreases, to evaluate different (best / moderate / worst) scenarios.

Regards,
Options Trading Beginner