Chris Tyler, Optionetics.com
April 14, 2011

Timing is everything they or umm, some market pundits like to tell us frequently enough. One place where that wisdom does seem to hold true is during earnings season and as it relates to option pricing. Preceding and then immediately following a company’s earnings report, investor tensions can mount and then even more quickly, collapse overnight as unknowns becoming cleared up and / or surprises, quickly factored into share prices.

In options-speak, traders can see that same behavior via the company’s call and put implieds. What’s sometimes called a “volatility rush” when implieds get bid up due to investor demand for protection can be quickly followed by a volatility crush once the proverbial cat everyone is waiting on; is out of the bag.

However, the math for profiteering from even the most (seemingly) extreme moves in implieds isn’t as straightforward as reading something like baseball statistics showing a batter rising through the ranks and which we can take as a truth; with or without steroids, mind you.

The greatest and really only factor standing between making a killing, by let’s say purchasing implieds in the 40s and selling them less than a week later in the 100s for an actual profit; is the Greek called theta or time decay. To not understand this very important factor and how it impacts implied volatility is a serious mistake.

One excellent and current example of this phenomenon where ever-rising implieds are going to bat against some very strong, growing and unwanted theta; well for buyers, is Google (GOOG). The internet search giant reports later tonight after the closing bell and with expiration for the April contract tomorrow evening, we have a great opportunity to see this relationship of rising implieds and theta at hard at work.

In front of Google’s results and over the course of the last handful of sessions since last Friday’s close, implieds in the mostly at-the-money April 575 straddle have gone from: 44% IV, 59%, 66%, 80% and intraday Thursday up to 115%. That’s an impressive sounding jump of 161% in absolute implieds.

On the other hand and while shares of GOOG have been relatively quiet around the strike (578.16, 577.37, 570.61, 576.28 and 575.61 intraday Thursday); the actual dollar pricing per spread has gone from: $28.85, $28.45, $27.45, $27.15 and $27.35 intraday Thursday.

Realistically, the current loss of $1.50 from last Friday when implieds were at 44% but now up to 115%, isn’t a great deal of pain as it represents about 5% of the straddle’s total purchase price. Tomorrow however could be a good deal more “taxing” if shares don’t move away from the strike for the long straddle holder.

Figure 1: Google (GOOG) -1 x April 575 Straddle

As it stands and with premiums now at 115%, more theoretically-oriented traders realize they’re pricing in a two-thirds chance or 1SD estimate that shares of GOOG will remain within 6% of current levels come expiration tomorrow night. If history is any indicator, that gives professional traders who typically take on short premium in these type situations; a better than average chance of profiting as Google’s average move is closer to the 4% to 5% neighborhood the last time I checked.

In saying that though and shown above as an illustrated one lot of that type risk using today’s prices; if for some reason shares experience a lower probability, larger-than-expected move and depending on just how the stock gets there i.e. gap vs. no gap; the environment could prove quite “taxing” for shorts holding through the event and currently, slightly in-the-money.

Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
Optionetics.com ~ Your Options Education Site