Tonight we combine the sections of Subscriber Questions and Team Trades because they cover a question on option volatility. (January 17, 2001)
Volatility (specifically, implied volatility) is one of the elements that makes up an options price on that part of the option that is out of the money. For example, if a stock is trading at $100 and you are looking at a $95 strike option, $5 of the option price is in the money. If the option price is $10, that means $5 of the price is time value and volatility.
The more time you buy, the more the option costs. When big news is moving the market, however, the volatility component can shoot higher. There are measures of historical volatility (e.g., Black Scholes) that help the investor determine if options are at high levels of volatility. AskResearch.com has a listing of this calculation. Typically, if there is big news out about a stock (e.g., split announcement, earnings), volatility on options moves higher immediately. Then as the news becomes 'older,' the volatility component falls, and that drops the option price. Thus, if you buy an option right when news comes out or early in the session after news comes out, you can actually see your option lose value or hold steady while the stock moves higher. Using this knowledge we were able to get a good trade on some AMCC options we had built a solid position in over the past few weeks.
After hours Tuesday AMCC reported solid earnings. It sold down right after the news, but on the conference call it shot back up. It gapped open over $7 this morning and was trading up $8 to $8.12 on its high early on. We knew with the big earnings news the options would be pumped up. Indeed, we saw a very early trade at $15 for a few contracts even though finding a bid and ask was not easy. The stock was having a hard time at the 78 level, so we decided that was good enough for us and put in a limit at $15. The main market came open with a $15.25 as the ask. About 5 seconds later we had been filled at 15.25. Wow.
The stock sold down below 77 in the first half hour, then moved up to 79.62 after about an hour. When the stock was at 79 (we sold at 78), you could sell the options for $15. Up a point and within an hour the volatility was already at work on the price. The stock then ran up to 81 by 11:30, but the options did not race ahead. The high trade we saw was at 15.50. When the stock was back at 79.62 at around 2:00 CT, the options were $14.75 by 15.25. $1.62 higher than when we sold, yet the bid was 50 cents less. The volatility was at work.
That is one reason we refrain from buying options on big news unless it is big news that we feel will hold, i.e., when a major leader ups its own earnings estimates or something really salty. On any pullback we are going to get hurt. We prefer to jump in after a pullback to suck some of that volatility off if we feel we can.
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