Option Premiums are directly co-related to the expected volatility input in Option Premium pricing.
With the results season in full swing, it makes sense to draw attention to the event and account for its impact on our day to day trading. With Equity Options being used as one of the most convenient tools to trade directional movements, accommodations during the results season here are unavoidable.
But before we talk about the accommodations, let us understand how results impact Option Premiums. Well, as all of us know one of the most integral parts of Option Premium pricing formula is volatility. This volatility figure is a reference to what the stock’s recent behaviour has been to a great extent. However, the volatility input in Option Premium is the expected volatility and not the volatility already registered.
The difference is not much in normal times in Expected and Recently Registered Volatility. When there is an event around the corner, for example, results, we do see this expected volatility input going higher. The announcement of results does have the capability to massively change the price trajectory, hence it is justified to have higher expected volatility in Option Premium before the results.
That is not it, there is a second impact also. Once the results are out, the unknown is known. This means now there will be normalcy with no surprise element left. Hence, the expected volatility that went way above the recently registered volatility will now come back down again to similar levels.
So, to summarise, expected volatility will rise disproportionately ahead of results and fall back to normalcy right after the results.
How does it impact Option Premiums though?
Option Premiums are directly co-related to the Expected Volatility input in Option Premium pricing. This means, rise in expected volatility, rise in Premium and fall in expected volatility, fall in Premium.
It is not unusual to see that before the results the All-Option Premiums rise a lot despite no great movement in stock. Similarly, right after the results, Premiums of all the Options fall in both Call and Put regardless of the direction of movement of the stock.
This is the impact that we have to understand and account for in our trading systems when we are trading in and around results. Adjustments should be made while trading in three different time spaces.
1.Option Trading Before the Results: Mostly the Premiums will be in rising mode here as illustrated before. It is advisable to be more on the Buy side because in this time space it will be difficult to make money out of Selling Options. Secondly, due to boost from rising expected volatility one may get away with small or no loss despite Stop Loss in the underlying, so get aggressive if you intend to exit before the results announcement.
2.Option trading during the announcement: The development is taking place. It could have a positive, negative, or no impact. If you have a Call or a Put buy, two out of those three impacts will create a loss for you. On top of that the fall in expected volatility after results will be yet another negative impact of the Option Premium.
a. Either do not buy it and if you must treat entire premium as loss. If the trade still makes sense then do it. Example: 100 Call @ 2.5 should be bought if the target is 107.5 or more. @107.5 premium will be at least 7.5 (double of 2.5 we spent).
b. Be careful in selling because it has a very thin possibility of a very big loss if the stock moves violently.
3.Option Trading after announcement: After the announcement the expected volatility and Premiums will be on the way down. So, avoid Buying Options. If you must, buy Call/Put and sell a Higher Call/Lower Put simultaneously. Profit will be lower and limited to the difference between bought and sold strikes (minus the premium paid) but the impact of drop in expected volatility will be handled to a great extent. After a day or so it should be business as usual.
These are some of the tips and tricks on trading Options during the results season. Knowing them is necessary so that we do not fall prey to the change in premium due to a change in expectation of volatility.
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