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