Options Sage submits:
As part of Wednesday’s Wrap-Up Phil summarized the outcome of last week’s educational play on BOBJ. For those of you that might have missed the commentary, I have included it below. If you’ve already read it feel free to skip to main topic of this week’s article – implied volatility (which had a big effect on the week’s educational play!) – where we’ll discuss why implied volatility is so important and what not to ignore!
Our educational play of BOBJ had earnings today and it turns out to be a great example of why I don’t like open calls (or puts) into earnings!
The earnings were just what I expected, good but not so great as to make the stock run away. After a nasty dip, the stock recovered to flatline at $38.71, just 1 penny higher than when we looked at it on Monday morning.
The 4 March $40 contracts that were discussed but not recommended were a $660 investment and held their value yesterday but dropped to $420 today ($1.05 each), losing 33% of their value as soon as earnings went past. The trade could have been gotten out of for $1.35 for the first half hour of trading, which would have recovered $540 of the investment.
Was this better than having taken $4,000 to buy shares of BOBJ? So far, no. If you held the shares through the dip to $37.82 in the morning (just 2.5%) you would be essentially even now. Remember, our goal here is to make $400…
Phil mentioned that the March 40 contracts lost 33% of their value as soon as earnings passed, despite the fact that the stock recovered to a price of $0.01 higher than where we looked at it Monday morning following a nasty dip. How is that possible? How could the option value drop so significantly after the stock ended up flat? The answer lies in the change in implied volatility!
Before we look at a chart, let’s first note that implied volatility represents an ESTIMATE of volatility in a security’s price. When implied volatility is high, option prices are expensive and factor in an expectation for considerable movement in the underlying stock. When implied volatility is low, the expectation for significant stock movement is low.