We are officially halfway through earnings season. But while the headlines have been focused on a few of the biggest names and their positive surprises…
…the rest of the market has been lagging behind.
As of Friday’s close, 51% of companies in the S&P 500 have reported Q2 earnings results.
Most have beaten estimates, but the margins are smaller than average. As a result, expected earnings growth for the quarter is falling, and currently marks the largest earnings decline reported by the index since Q2 2020.
If that trend continues further, we can expect a shake up in market volatility, and you know what that means… a spike in options implied volatility.
I love heightened levels of volatility. It’s the stuff option traders long for.
It’s too bad that many of those exact same traders misunderstand the role volatility plays in option pricing, which means they often end up leaving a lot of potential profits on the table.
Luckily… I have one easy rule that will help you avoid this issue any time you trade options…
How Options Greeks Directly Impact Your Profitability
As I’ve covered before, options are investing instruments that make (or lose) money based on a few specific things – the underlying stock moving, time passing, and implied volatility (IV) fluctuating. The exact dollar impact on an option’s value is revealed by indicators called “The Greeks.”
There are five option Greeks you’ll hear about – Delta, Gamma, Theta, Vega and Rho, but let me keep it simple for you and just focus on one of them today: Vega, which is one of the key driving forces behind option profitability.
To keep it simple, you just need to remember two things about Vega:
- The Vega sign (+ or -) indicates whether the option is long or short. Long options have positive Vega, and short options have negative Vega.
- The value of Vega refers to how much your investment might make or lose if the implied volatility (IV) moves up or down by 1%.
Let’s look at the Vega value for the Starbucks (SBUX) long call option below. This is a long call, so the Vega sign is positive, which means the trade benefits when implied volatility rises in value.
Notice that VEGA has a value of $8.22. This means that if IV increases by 1%, Vega will add $8.22 of value to the position.
Whenever I talk about Vega, I have to talk about earnings season. This is where implied volatility — and a concept I refer to as IV Rush — can make or break your option trades.
Let’s stick with this SBUX chart. So, we know that Vega tells us this option’s value will increase by $8.22 for every 1% IV increases. Historically, the IV on SBUX options rushes almost 200 percentage points 12 days before earnings. That adds over $1,600 of Vega value to the call.
(Of course, the other Greeks also push and pull on the option’s value, which is why it’s worth taking the time to understand how each works.)
Most people buy options during earnings season as a bet on direction, with the plan of holding them over the announcement.
However, check out what happens to IV the next trading day after earnings (green E’s on the chart) are announced.
Looking at the chart above, it’s obvious how much more IV rises right before earnings announcements compared to any other event. As IV rises, the option’s value increases, so if you buy an option as IV starts to rush, the option will benefit from IV rush. That’s good. This is my preferred way to trade options during earnings season.
What’s bad — and what most traders get wrong — is that IV tanks following these announcements. If you sell your option right after IV has tanked, your only way of making money on your option is if the stock moved in the direction you bet it would (up for calls, down for puts).
Long story short: Pay attention to Vega, and don’t let tanking IV sink your profits!
While Vega isn’t the only Greek you should be focusing on, it’s much easier to make money if it’s working in your favor. You don’t want falling IV to suck all the value derived from Vega out of your option. That’s money you don’t want to — and don’t need to — leave on the table.
See what a difference it makes when you take time to understand options?
To your continued success,
Tom Gentile
America’s #1 Pattern Trader
