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Question By Gaurav Dixit
"Why Did My Call Options Decline on Positive Earnings?"
If the stock is traded at 3600 and we purchase the call option with a strike of 4000 at a premium of suppose 10 and the next day there is the positive results of the company came but still the premium of stock decline, why it would happened ?
Asked on 21 Feb 2014
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Answered by Mr. OppiE
Hi Gaurav Dixit,
Indeed, this is a common frustration amongst stock traders new at options trading who wish to utilise the power of options leverage on earnings release speculation. You will find that most often than not, you will not profit by buying call options through earnings release even if the earnings result was positive. Why is this so? There are two main reasons to this.
First of all, the obvious reason may be that some stocks just don't go upwards even on a positive earnings release. This is an uncommon occurrence but since you did not mention this aspect in your question, I am going to take it as a possibility. Now, the next reason is the main reason why options don't work through earnings release even if earnings result is positive, an options specific phenomena known as...
Volatility Crunch! (learn more about Volatility Crunch)
Let me explain this in a non-technical layman way. Options premium builds up strongly leading up to volatile events like an earnings release. This means that options start to get more and more expensive even if the underlying stock didn't move. What this does is pricing in the expected movement into the options premium in order to correctly value the option based on the Black-Scholes Model. The logic is that an option that gives you access to an expected strong movement in the underlying stock would be worth more than an option that doesn't. This build up of premium value comes to a climax usually on the day before earnings release... that's when you bought your call options... at its most expensive. Now, what follows is what is known as Volatility Crunch...
The huge build up in premium value IMMEDIATELY EVAPORATES the moment earnings is released. The logic is of course that there is no more expectation of huge volatile movement AFTER the volatile event is completed. This huge chunk of value disappearing from your call options is big enough that if the stock actually not moved or moved not in a significant way upwards, you will actually end up making a loss. This is most prevalent in out of the money call options, which sadly again, was what you bought. This is how most beginners lose money speculating on earnings release using call options bought the day before earnings release. Unless the stock moved in a HUGE way, you are unlikely to make a profit.
In fact, most professional options traders typically do the opposite of WRITING call and put options (known as a Short Straddle) on the day before earnings release on options that has extremely high extrinsic value build up and close the position the moment volatility crunch happens. They, of course, sold those options to people like yourself trying to speculate by buying call or put options on the day before earnings release. The other way most professionals speculate on earnings release is by buying call options way before the premium build up happens. In fact, I typically advise my Master's Stock Options Picks subscribers to buy no less than 3 weeks before earnings release so that you actually profit from the premium build up leading up to earnings release. Alternatively, if you bought deep in the money options with very little extrinsic value and very high Delta, you would also stand a better chance at profiting from a positive earnings result but since most beginners are using options for leverage, few are willing to buy expensive deep in the money options.
In conclusion, buying call options on the day before earnings release, especially out of the money options, is a strategy that most often than not result in a loss. The chances of winning is very slim and only if the stock moved in an extremely strong way.
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