Careful When Buying or Selling Option Premium Ahead of Earnings

In this piece we re-visit an article from 2009 about the high implied volatility on a stock's options ahead of earnings.  This case study is a useful, timeless example with real prices that shows the considerations an advanced option trader faces.  Ironic that RIMM was then trading at 75 and now is 12 ... it shows how quickly things can change in many market sectors.

June 17, 2009:  Research In Motion (RIMM), the maker of BlackBerry smartphones, is due to report quarterly earnings Thursday, June 18th, after the market close.  An examination of RIMM options ahead of this earnings report is a useful case study of pre-earnings options pricing. 

RIMM options are expensive right now ... very expensive.  The June At-The-Money options are priced at about 150% implied volatility, even though they cease trading at the close on Friday, June 19th. 

Why?  Because the company reports earnings Thursday evening, and the market (specifically option traders and market makers) is anticipating a big move.

You can see on the following volatility graph that RIMM options implied volatility (blue line) are trading way above its current statistical volatility (brown line).  As of the June 16th closing data, Implied Vol. was around 65% on average versus Stock Vol. of around 40%. 

So the time premium on RIMM options is very expensive right now, one might call it "juicy".  But are these juicy premiums an "automatic sell" ahead of earnings, banking on a volatility implosion after earnings? ...not necessarily.

RIMM has a history in the recent past of volatile reactions to earnings, in both directions.  In the table below, we examined the last 6 RIMM earnings reports. 

You can see that the stock has made big moves in both the 1 and 5 trading days following earnings.  The 1 day reactions alone range from down 27.5% to up 20.8%; the lowest 1 day move was 5.9% (close to close basis).  The average move over the data surveyed was plus/minus 14.9% for the day following earnings, and 17.2% for the 5 trading days after earnings.

These RIMM option prices are from June 17th, 1 day ahead of earnings (and 2 days ahead of June options expiring).  They may be oruced very different tomorrow before the earnings are due.  But in the current pricing data, with the stock at 76.90 and down on the day, the June 75 Straddle was priced at around 8.50.

This is an astounding implied volatility of around 152%, with only 2 trading days left until expiration.  But more importantly for our purposes, this At-The-Money Straddle is pricing a move of about 11.1% on the shares.

Although this is a fairly small sample size of 6 previous earnings reports, you could say in a way that you are getting 4% underlying stock move "edge" by possibly buying the June At-The-Money RIMM Straddle at these prices.  Based on the recent data, the 150% implied vol options may be underpriced, not overpriced as one normally might think.

If RIMM moves 15% the day after earnings for example, the shares would move about 11.50 on these prices (versus paying 8.50 for the straddle).  If RIMM only moves 5%, which is the low end of the range, that equates to a move of around 3.85.  This is certainly not a "risk-free" trade, but it is an example of how extremely high option volatility and premiums cannot automatically be considered to be a "sell".

On the following RIMM Daily Chart, you can see the massive gap that occurred after the last earnings report, when the stock gapped up about 10 points (20%) on the open.

Could RIMM implied volatility "implode" after this week's earnings report, dropping sharply?  Certainly. The July and further out months may see a sharp drop in option premiums.  The June options, which expire Friday, will basically become dollar-for-dollar as expiration approaches.

There are other advanced strategies that investors/traders can consider in situations like this, such as Buying June Options/Selling July Options, Strangles, Condors, Credit/Debit Spreads, Diagonals, etc.  There is no definite guaranteed risk-free strategy when trading ahead of a news event and expiration.  But it certainly shows that option prices should be looked at from a variety of angles by the advanced option trader. 

RIMM actually moved down around 4.12 points (5.3%) from when this report was done until the Friday close.  This was basically around in line with the lowest 1-day move we had tracked, but the "jacked-up" straddle at 8.50 was in this case a good premium sell ahead of earnings.