Hello, Power Profit Traders!
You don’t have to be a trading pro to know that if you continue to pump hot air into a balloon, you’ll only expect one outcome!
POP! Let’s just hope you didn’t get hit by the latex shrapnel.
I know it’s easy for traders to be lured into idea of a big move accompanied with earnings reporting, but the result often leads traders feeling they’ve been caught in a snare.
There’s something critical about earnings and option premiums that you should never lose sight of. It’s the reason traders lose money when trading through earnings.
Traders who understand the influence of implied volatility have an advantage over those who don’t.
One thing is certain – you do not want to be on the wrong side of implied volatility. It’s the best way to lose money on an option trade even when things have seemingly gone your way.
First you need to understand a little about what makes up the price tag on an option – the option’s premium.
There are two main components that make up an option’s premium – Intrinsic Value (IV) and Extrinsic Value (EV).
Let me break down the components that make up option premiums and explain what goes wrong for so many earnings traders.
Intrinsic Value (IV)
The first component of an option’s market value is intrinsic value. When a stock’s price has risen above a call strike price it is considered in the money, and it now has intrinsic value. Don’t mistake in the money to mean the option is making money, however.
A put option on the other hand is considered in the money when the security falls below the strike price.
So, if Microsoft (MSFT) is trading at $251.90, the $250 call strike price is in the money by $1.90, and the option premium will reflect that amount as intrinsic value – the option will be worth at least $1.90.
Looking at the illustration below, the $250 call is shown with three different expirations – July, August and also October.
Take note that all three expirations have the same amount of Intrinsic Value – $1.90. This is because the stock’s price is trading at $1.90 above the $250 strike price.
The other component of an option premium is Extrinsic Value, or the amount of money being paid based on the number of days remaining until expiration.
(MSFT: Option Premium = IV plus EV)
Extrinsic Value (EV)
In addition to intrinsic value, an option’s value will have a component of extrinsic, or time value.
The more time there is between now and an option’s expiration, the greater the time value portion will be.
In the image above you will notice that the July, August and September $250 call have different market values. Since the intrinsic value is the same amount for each expiration, the difference in premiums across the three months is based on how much time is remaining – the extrinsic value portion.
Now that you have an understanding of the two components that make up an options premium – its market value, let’s discuss how time value can change – become inflated or deflated.
Implied volatility is a very important piece to an option’s premium.
Option premium inflation occurs when demand picks up. The underlying stock’s price may not change a single penny, but as demand for the options picks up, so do the option premiums.
Extrinsic value increases, and thereby, option premiums increase!
Consider the Superbowl. This is an event that will sell out quickly, but then you can find “entrepreneurs” selling tickets to a sold-out event at super-inflated prices. After the game, however, you couldn’t give the tickets away. They have little to no value.
When a company prepares to report its earnings, traders begin to speculate and hedge heavily. This creates much higher demand than normal – just like the tickets to the sold out Superbowl event.
Once the event is over, or in other words, once the earnings have been released to the public, the hype is over.
This is exactly why too many traders lose money when they buy options before earnings and hold them after the announcement is over – the inflated premiums are drained.
After the earnings are released, the balloon pops! Option premiums experience a rapid decline in inflation soon after the report.
Option inflation can fall so sharply that traders find themselves with a losing trade despite the fact that the stock moved in their expected direction on the earnings report.
It’s also why I use proprietary software to find trades to enter before earnings, but exit before the implied volatility implosion.
Now that you’ve learned how implied volatility impacts option premiums, you’re one step closer to successful earnings trading.
You can watch Tom Live Monday through Wednesday, but if you miss him, you won’t miss a beat. Just click below and watch his replays!