A Lesson in Volatility prior to Earnings Releases: Google Options

by Darwin on April 20, 2009

For investors that follow the options prices of tech stocks and other volatile companies, they may have noticed that the stock options seem to get “expensive” and “cheap” during certain periods, namely, before and after earnings announcements or other major events.  Since the primary tenant of investing is buy low and sell high, how about sell high and buy low?  This entails selling stock options when they’re expensive and buying them back, or closing them out, when they’re cheap.  As evidenced below, utilizing this method last week surrounding Google’s earnings announcement was an easy way to capture an attractive one day gain with what I deem to be moderate risk:

By Selling a Put option and a Call option simultaneously 10% from the current share price, investors netted an $810 gain in a single day, even though shares moved up following the earnings announcement!

How Could this Be?

Just look no further than what happened between Thursday (pre-announcement) and Friday (post-announcement).  Thursday’s close was ~$389.  I took a snapshot of the options prices Friday morning after the announcement when shares were up moderately at $396.  If you look at the May $430 contract for a call option, (recap, shares moved from $389 to $396 overnight), the option value actually DECLINED!  Thursday afternoon, the option contract was worth 8.40 and Friday morning, it was 5.40 for a 1 day $300 gain (with shares moving toward, not away from the $430 strike).  How could this be? When a stock is rising, the call options should be increasing in value, right?  Well, that’s when you forget to consider the volatility component of the option value.  Simply put, leading into the earnings announcement, implied volatility on Google options was quite high, and then following the announcement, it dropped off a cliff because the news was out.  Put another way, just prior to earnings, investors figured there’s a chance that shares would skyrocket, hence they were willing to pay more money for an “out of the money” call option at the $430 strike thinking that perhaps shares would zoom right past and they could pocket the difference.  When the earnings announcement was met with a yawn though, the likelihood of that scenario deteriorating quickly, hence, the much lower price.

Now, for the Puts

Likewise, if you had sold a put option ~10% below the share price, you sold the May 350 Put for 9.50 and by the next day, as would normally be expected, since shares were moving in the upward direction, the put option had dropped to 4.40, for a $510 1 day gain.

The Risks Should Not be Ignored

I don’t want to portray this as a no-risk or even a low-risk proposition.  I happen to be long a few Google shares and many funds and ETFs I hold have exposure to Google and tech in general which would be buoyed by a massive runup in shares.  However, if Google shares rallied say 20% in a day, the call option may then have run to about $5000 to buy back.  Now, since you had sold the put and call combination for a total premium for ~$1800 combined and now we assume the put will just expire worthless or be very cheap to buy back, you’d be looking at a loss of $3200.  Could Google run 20% in a day?  In recent history, that hasn’t been a typical pattern, even following earnings announcements, but that’s a risk you have to be willing to assume.  Your other alternative would have been to sell credit spreads which I outlined in an article at Everyday Finance, but by taking on less risk, you reduce your profit potential.

What’s Next?

Apple (AAPL): Next Earnings Release will be Wednesday after the bell.  Those options are looking to fall into a similar pattern of pricey early in the week and likely cheaper (assuming we don’t see a massive run on shares) by Thursday.  Perhaps that’s another tech bellwether worth selling on volatility and buying back on the yawn.

Options Basics and Other Plays

I had posted somewhat routinely about options basics and other options plays at Everyday Finance; here are a few such articles for the uninitiated:

My Twitter Followers that Made 285% in 1 day Today

Google Credit Spread Expired for easy $750…Next?

Apple Covered Call Play Round 2: Capture Gain and Repeat

Whirlwind Week Trading Update – Saved by Apple and Google

Trading Update – Recovery Edition II

Is This the Rebound? A Financials Volatility Play(apparently, it was the bottom…I wrote in on March 12!)

Apple Covered Call Revisited: Same Share Price at $95, but I’m Up $600

Disclosure:  I have a covered call position on Apple already, so I will not be engage in any additional option trades.  I also own Google shares and have an open credit spread position on the put side.

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{ 3 trackbacks }

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{ 2 comments… read them below or add one }

1 Jae Jun April 21, 2009 at 1:56 pm

For some reason I still don’t get options… I seriously need a crash course or something.

[Reply]

2 Kirt Christensen September 4, 2009 at 3:34 am

Nice topic. clear and concise. Makes me realize new strategies.

For beginners there’s sure a long way to go.

@Jae Jun
Read more articles. There are lots of theories that might be helpful depending on what type of investor you are. Just play the game with their rules.
.-= Kirt Christensen´s last blog ..Options Trading FAQ =-.

[Reply]

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