With Apple Inc. (AAPL) expected to announce their earnings this coming week and a plethora of companies afterwards, it is probably a good time to review how an option price can be influenced by earnings. Many option traders view quarterly earnings as a perfect time to trade options and in fact they can be. But there are plenty of considerations to take into account.
Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.
The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a direct result of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.
The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we will be in the midst of earnings season soon, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium.
The value of implied volatility is generally inversely correlated to the price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price like a quarterly earnings announcement. In addition, FDA decisions, potential takeovers and sometimes product announcements can also effect the implied volatility and option prices just to name a few more.
New traders as well as veteran option traders that are beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. In addition, this applies to all option strategies even those not based on an earnings report. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.
John Kmiecik
Senior Options Instructor