Friday, July 10, 2009

Earnings... the Wrench in the Theta Clock

Consider this:

Does theta work like normal when there is an earnings announcement between now & expiration? In other words, If I’m considering a positive theta trade (short strangle, iron condor, calendar spread, etc...) by selling July expiration options; can I expect time decay to erode away at the value of these front month options if there is an earnings announcement right before July expiration?

The answer is usually no.

GOOG serves as a good case study as it reports earnings next Thursday, 1 day before July options expiration. Would it be wise to place a July short strangle today in an effort to gain exposure to 4 or 5 days of time decay, or should we wait until next Thursday to place the trade?

Truth is when an earnings announcement release occurs close to expiration, the effect of time decay is negligible. Thus, although Theta increases exponentially as expiration approaches, the price of an OTM call or put may remain higher than Theta would lead you to believe.

In addressing this subject in The Volatility Edge in Options Trading, Jeff Augen asserts: “The effect we are discussing involves a decoupling of option prices from the current behavior of the underlying security. This decoupling seems rational when you realize that options, like all securities, are priced by the aggressiveness of buyers and sellers. Many investors falsely believe that option prices are set according to the familiar mathematics of volatility and time. In fact, the opposite is true; prices are set by traders who buy and sell contracts using the mathematics as a guideline… It is completely reasonable for the two to decouple, and that is often what happens when earnings are approaching.”

Let’s look at an OTM call option on GOOG to illustrate. GOOG is currently trading around $414.50. The July 420 call is at $10.80 and has a theta of -81, meaning that theoretically this option should lose $81 a day due to time decay. Utilizing an Options Calculator we can forecast how much the July 420 calls should decline in value day by day until expiration. We’re going to assume GOOG stock price ($414.50) and implied volatility (54%) remain constant throughout the exercise:

As the table illustrates, we can reasonably expect OTM GOOG options to decay rapidly into options expiration. However, this will not be the case with July expiration. As Jeff Augen points out, there is a “decoupling of option prices…when earnings are approaching”. We’ve mentioned previously that option traders aggressively bid up option premiums in anticipation of a company’s earnings release. This aggressive demand drives up implied volatility and keeps the July 420 call option value higher than what the table above implies. Although the 420 calls are currently trading with an IV of 54%, odds are IV will be much higher next Thursday in anticipation of the large gap that often occurs in GOOG’s stock price after earnings.

In addition to the negligible effect of time decay, this continual rise in implied volatility in anticipation of an earnings release serves as another reason as to why it is prudent to hold off on entering short volatility strategies until the day before the earnings announcement. After all, no sense in entering a short strangle on GOOG(or any stock for that matter) right now if it can be entered in 4 or 5 days at much higher volatility levels.

For the aforementioned reasons, I generally wait until the day of earnings (assuming they report after hours), or day before (if they report the following morning) to enter any short volatility strategies.


Mark Wolfinger said...
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Not bad