The Significance of Time Value

Let’s imagine we have two call options at the 50 strike with the same expiry date, like this:

	Stock Price	Option Price	Intrinsic Value	Time Value
Stock A	$51	$2	$1	$1
Stock B	$51	$3	$1	$2

There are two stocks, each at the same price. We are looking at identical options for each stock, with the same strike price and expiry date. However, Stock B has an option that is more expensive than Stock A. Why would that be?

The intrinsic value of the options is the same, because that depends on stock price alone. But the options have differing time value, and that’s why one option is more expensive than the other.

Why do you think they would have differing time value, if they both expire at the same time? Please think carefully about this question.

• Intrinsic value cannot be adjusted by investors … it is fixed according to the price of the stock.
• Time value, however, fluctuates every second that the market is open.

Time value is the amount that investors are willing to pay for the PROBABILITY that the stock will move and increase the intrinsic value of the option before the option expires.

An option with a higher probability of becoming more profitable, due to stock movement, has a higher time value because investors pay more for a higher probability of profit.

Therefore, a stock that is EXPECTED to be more volatile (have larger moves) tomorrow will have options with more time value today.

To drive this point home, I have placed two stock charts below. Which stock do you think will have options with the most time value?

Click to enlarge

Taking a close look at the KMI chart on the top, you can see that KMI has only moved about 3% in the last three months.

FISV, on the other hand, has moved more than 6% in the last three months, not including the 10% jump a couple of days ago.

The FISV options will be much more expensive than KMI’s, because they will have greater time value.

Letter from Anna regarding risk calculation

This letter from Anna is in response to the questions and comments to the article at http://tradealert.wordpress.com/2006/10/27/anna-not-bad/ 

First let me tell you that all of those stocks, in question, are in my ER Box. That is, I have traded all of them before and keep a lot of information (perhaps only relevant to me) about these things:

• IV / HV
• How fast / slow IV drops
• How many days it takes the stock to move

Yes, I am aware that IV drops, but did you know that sometimes it drops a little by little, and sometimes it just plunges down! Both have happened to me a few times, so I know! Because of my ER Box I more or less know how those stocks behave before, during and after ER. So when I take a trade I more or less know what to expect. (Of course, it does not mean that there are no surprises!! Oh yes, sometimes there are!! And when the suprise comes, it’s a big one, and could be positive or negative, hahaha)

Note from Ben: I just wanted to show you what Anna meant when she said that IV often takes a couple of days to reach the worst-case scenario – click on this IV HV chart for HAR to open it in a new window, then look at how HAR’s IV fell after earnings on Aug 15th. As each day went by, IV fell to: 44%, 39%, and finally to the HV at 35%.

Can you see a similar pattern happening after earnings on Jan 25th? Back to Anna:

But that does not stop me taking a trade, if – and ONLY IF – I find it feasible for me!! … here comes my rule #1:

No matter how nice the potential profit looks, if my potential loss is higher than I can live with, I only paper trade it! [Like HAR with 165% paper profit]

My limit on ER trade for risk is 30% – 35% max, as Mirriam has also told us.

Yes, when the stock price is away from the strike price, I do use strangles whenever I can, and I use Mirriam’s rules to determine if it is a good idea, or just stay out of the trade.

HAR:

In HAR my potential (expected) loss was 29.6%. I was a bit concerned about the difference between IV 42% and HV 19%, but I was expecting IV to drop to 32.6%. (Take a look at the HAR’s HV IV chart, above. You will see that 32.6% was a very reasonable expectation for the first day of IV drop) I knew that HAR would make a big move, and that it would make that move on the first day. The great thing is, that when I sold my call with 165% profit, IV was 34.3%, very close to my prediction.

In the last 3 quarters that I have traded it, the stock has always moved big in the first 1 to 3 days. And you see, despite all of this, I still had a bit of a ?-mark in my mind, and I played it ‘safe’ and paper traded HAR. (I wish it was real, but I am ok with it … it did what I expected from HAR, so next time I will have more information.

NVT:

As I said, I am beginning to know my ER stocks. NVT is one of my big movers, too. In July’s ER, NVT moved -12.60 in the first day. IV dropped from 64% to 42% at the same time (and I made my best % profit of 263% with it).

Based on this information and my present calculation, I was confident that should NVT make even the minimum jump, I could capture 50% profit. I calculated my risk as 32%, assuming the IV would fall from 76% to 54%.

Note from Ben: click on this picture to open it, and see how IV did fall to 54% on the first or second day after earnings. Once again, Anna’s assumption was correct. By looking at the IV chart, you can see why she chose 54% as her first level of support for IV. Anna was absolutely aware that IV would continue falling beyond that point in the next few days. Note how she emphasised that she knew NVT always jumped quickly, so she intended getting out before IV fell all the way down.

GYI:

I can only say the same as I did about the other two: Looking at my notes from July and making the calculation for this ER gave me enough information to take the trade.

One more thing:

My worst-case scenario goes like this: present IV and HV give me an idea what to expect from the stock after ER in about 1-5 days to 3 weeks’ time. Based on my experience after ER, stocks tend to go back to their HV at latest by the week of expiration on our options (as we buy the front month) and that is about 3 weeks from our entry.

Sometimes, for whatever reason, the stock doesn’t move, and when that happens, IV DROPS HARD! I cannot imagine anything worse than that. When this happens, I will lose big. Therefore I try to find out what value of IV will give me a loss greater than 30%. If I feel it is likely that IV could fall to that value, I won’t take the trade.

And NO, I DO NOT GAMBLE! I lost my initial capital 2x before I got where I am now, and built my account back with only one contract per trade, so trust me, I do my home work before I take ANY trade. I hope these answers give you what you were looking for.

 

How far can IV fall?

We already know that IV falls after an earnings announcement, according to the HV / IV dance mentioned in the last post.

It’s quite a logical process … before the announcement, investors are expecting the stock to jump, so they pay more for the options’ time value. After the announcement, the stock has already moved, and investors are no longer expecting the stock to move any more than a normal stock would. Therefore, they immediately pay less for the option’s time value the day after the announcement. That’s why IV falls so suddenly.

After the announcement is over, and the stock has gapped in one direction or the other, it will probably resume fairly normal price action, with the same historic volatility as it had before the earnings report.

We can’t be sure that the

Comments on the ADSK strangle

I gratefully made 85% profit with real money on ADSK earnings today. It could have been around 110%, but I messed up the exit pretty badly. The option price peaked exactly half an hour after the market opened. I sold earlier than I should have.

Warning level has reduced 

As you know, the “October Blues” article indicated that I had stopped trading real money. The second week of November hasn’t been as good as those we are used to, but there were enough winners in my paper trades to make me reduce my personal warning level from “paper trade and watch” to ”only the trade the very best candidates with real money”.

As you will see from the discussion below, risk on the ADSK strangle was 30%. In the past I have seen strangles with less than 20% risk. However, since the beginning of October until just now, I have not seen a strangle with less than 50% risk. Amongst a growing number of successful trades, this is another sign that the “wind” is beginning to blow back in the direction of earnings.

Whats your commitment? 

At this point I’d like to encourage you to trade or paper trade earnings every single day, no matter what’s happening in the market. I have analyzed every single earnings candidate every day for the last year, and that’s why I was able to recognize and profit from the ADSK opportunity. What’s your commitment level?

If you commit half-heartedly, you’ll get half-hearted results. What results do you think you will achieve if you commit with all your heart?

Praise for Mirriam’s idea 

While I’ll get to the specifics about this trade soon, let me also praise Mirriam’s guideline for strangles:

The “$ Min Jump” must be more than the distance from the stock price to either strike, because that’s approximately the jump required to get the options into profit.

I don’t use “absolute rules” in my trading, (preferring to learn to “understand” the situation) and I don’t use this as a rule, because I use the Trade Calculator tool in Trade Alert to figure out my break-even points. But I personally admire its simplicity and completeness as a rule of thumb. I wish I thought of it myself

Yes, I use this rule of thumb to quickly skim candidates and decide which are the first ones I will analyze.

Specifics about the ADSK trade 

As you read, please remember that the following points are not “rules” for me … they are just things that I added to the basket of observations that helped me make the decision:

• It was a golden candidate (using “Max Days For Jump” setting = 2)
• ADSK’s option chain had strikes every $2.50, even though it was a $36 stock.
  • meaning the strangle didn’t have such a wide “dead zone”
• $ min jump was more than the distance from the stock price to either strike price.
• Stock just happened to pass exactly over the midpoint between strikes around about US lunch time, meaning I got in nice and cheaply. Cheaply, because IV is lowest at lunch time, and the stock was exactly in the middle. 

Pre-market preparation 
However, I didn’t make the decision on the spur of the moment. I had done my pre-market research and decided before the market opened how much I was willing to pay for straddles and strangles. I was waiting and watching for the cheapest entry point.

Do you calculate the amount you are willing to pay for a straddle or strangle before the market opens? Or do you try to do things on the fly, pressured by fast-moving prices?

I know how much I am willing to pay for a straddle by the following: I work out what purchase price will give me 30% risk. Anything more than that is too expensive. However, I also calculate my expected reward. The expected reward must of course be much more than the risk or I won’t take the trade.

Click to enlarge image

Implied Volatility

• Used 30% as my estimate of worst-case IV, and IV actually fell to 32%. You can enlarge the HV IV chart for ADSK on the right to see why I chose this level.
• At this worst-case IV, the resulting risk on the strangle was exactly 30%.
• Calculated the potential profit I would receive if the stock jump the “$ Min Jump” amount at the current IV and found that it was between breakeven and 7% loss, so I knew that the min jump would see me at least not losing very much.
  • (Using “Max Days for Jump” setting = 2)
• Calculated the potential reward using the “Expected Jump” value and it was a bit better than the worst-case risk.
  • (My “Max Days For Jump” setting = 2) That setting effects the jump amounts quite a lot.
• Looked up the news for the stock and found that it had at no time released any earnings “guidance”, “estimates”, or “warnings” recently … sorry to add that dimension of complication, but I have found that stocks that release earnings guidance, warnings, or estimates prior to their actual announcement generally jump a bit less.
  • I don’t use this point or any other point as a “rule” — I just add it to the basket of observations that help me make a decision about taking a trade.

This point is very important (in my opinion)

• Unlike many stocks releasing this quarter, ADSK had NOT made an anomaly, record-breaking jump in the previous quarter.
  • As you probably read in my latest blog article, stocks cannot make record-breaking jumps every quarter!
  • I am not talking about a few percent higher than ever before, (that doesn’t really matter) but hugely higher, anomaly jumps. eg … 5%, 5%, 5%, 15%, (not such a good idea to trade in a quarter after a quarter like that) !!
  • YHOO was one example of a loser … do you remember the excitement about its huge, record-breaking jump two quarters ago, and then how it died the following quarter?
  • There have been many such examples this quarter.

This point is not very important in my opinion at the moment, but it did help my decision:

• ADSK made a huge, record-breaking jump in the third quarter last year.

Conclusion
Phew!! That was a lot of detail I hope to receive lots of feedback / questions / comments and especially challenges from this article, so post away, I’ll be glad to hear from you. Do also help to clarify things for the other readers, if you see a point I could have explained better.

 Good trading,

Ben

The IV / HV earnings dance

There is an IV / HV dance before, during and after an earnings announcement. Can you guess what it is?

I think you already know that IV increases to a very high value before earnings, and then falls drastically just after earnings, often cutting the profits you would have made, even if the stock moved!

But did you know that this cycle is entirely predictable?? You can predict how far IV will increase, and you can predict how far IV will fall!

Now, isn’t that wonderful? It really is good news … it helps you cut out all earnings strategy trades that have high risk, and literally doubles your profitability, I promise.

What I am about to share with you is cutting-edge information, and highly unknown to retail traders like you and I, so you are extremely lucky to have this information.

Once again we will refer to the stock chart and IV / HV chart of yahoo:

Here are the rules:

1. Before earnings, IV rises to the AVERAGE, REASONABLE value that you can expect HV to be the day after earnings.
   
2. After earnings, IV falls to the AVERAGE, REASONABLE value of HV before earnings.

As with all rules, these rules must be taken and used in the context of common-sense and understanding. You must learn to recognize when you are being “fooled” by simplicity. Future lessons will cover these extra things you need to understand.

With the earnings strategy taught by Mirriam MacWilliams, you can use rule 2 to determine your worst-case scenario.

The worst-case scenario is a calculation of your loss if the stock fails to jump (stays at the strike price), and IV drops the maximum amount that is possible. You can see me calculating worst-case scenarios live in the live trading videos on this website.

If the worst-case scenario results in a possible loss that is more than 20% or 30%, you know that you shouldn’t take the trade.

If the worst-case loss is less than 20% or 30%, you can go ahead to determine your likely profits … if they are comparatively much larger than your worst-case loss, you can go ahead with the trade. We will look at these calculations in more detail soon.

But first, we must examine the HV / IV dance more closely in the next few lessons.

What is IV?

Let’s imagine we have two call options at the 50 strike with the same expiry date, like this:

	Stock Price	Option Price	Intrinsic Value	Time Value
Stock A	$51	$2	$1	$1
Stock B	$51	$3	$1	$2

There are two stocks, each at the same price. We are looking at identical options for each stock, with the same strike price and expiry date. However, Stock B has an option that is more expensive than Stock A. Why would that be?

The intrinsic value of the options is the same, because that depends on stock price alone. But the options have differing time value, and that’s why one option is more expensive than the other.

 Why do you think they would have differing time value, if they both expire at the same time? Please think carefully about this question. 

• Intrinsic value cannot be adjusted by investors … it is fixed according to the price of the stock.
• Time value, however, fluctuates every second that the market is open. 

Time value is the amount that investors are willing to pay for the PROBABILITY that the stock will move and increase the intrinsic value of the option before the option expires.

An option with a higher probability of becoming more profitable, due to stock movement, has a higher time value because investors pay more for a higher probability of profit.

Therefore, a stock that is EXPECTED to be more volatile (have larger moves) tomorrow will have options with more time value today.

You already know that HV (historical volatility) is a measure of how volatile a stock’s price has been in the past.

If investors expect the stock to move TOMORROW such that it will cause the stock’s HV to BECOME 70%, they will pay a certain amount for the options’ time value.

If the investors expect the stock to move TOMORROW such that it will cause the stock’s HV to BECOME a lesser amount, they will pay less for the options’ time value.

Investors needed a measure of the amount that people were willing to pay for the option’s time value … the measure needed to be standardized so that:

• The measure resulted in a prediction of the stock’s future HV value
• The measure was standardized across different times to expiry, interest rates, and more or less expensive stocks. (These are other reasons to increase and decrease an option’s time value)

The Black-Scholes model was invented to satisfy these requirements, and a measurement known today as implied volatility was the result.

It is called implied volatility because it uses the option’s current time value to determine the market’s expectation of future stock HV.

We will again use the Yahoo stock chart and IV / HV chart to examine the relationship between IV and HV:

Before an earnings announcement, investors are expecting a stock to jump in either direction. Because the stock is about to jump, investors are expecting the stock’s HV to increase to a certain value, which they estimate from previous jumps.

Look at the very first earnings announcement in August 2005, on the far left of the chart. It caused the stock to jump so far that HV was increased to just over 40%.

The next earnings announcement was in the middle of October 2005. Investors were expecting the stock to repeat history and jump far enough to increase HV to slightly over 40%. That’s why IV, (the orange line) showed 40% at that time. The stock’s jump disappointed investors, however, (HV only rose slightly, to 28%) so in that instance, they paid too much for the option’s time value.

In the next quarter, January 2006, investors once again were keyed up, waiting for the stock to jump. IV rose to 42% in expectation that the stock jump would increase HV to 42%. This time, the stock did not disappoint, and it jumped even further than expected, raising HV all the way to almost 50%!!

You can see that the April 2006 price jump did not cause HV to rise very high … investors once again had paid too much for the option time value.

The July 2006 earnings announcement caused such a HUGE stock price jump that the HV value rocketed to an amazing 77%!! This time, investors had underestimated how far the stock would jump.

You have probably noticed that, even though IV is trying to predict HV, it is usually quite inaccurate. Investors are doing their best to pay the correct amount for an option’s time value, but they never can be sure what the stock is going to do.

In fact, investors use the average of a stock’s previous jumps to guess how far it might jump in the future. If they see that, generally, when a stock has an earnings announcment, it jumps far enough to increase HV to 40%, they will usually pay enough for the option’s time value to increase IV to 40%.

Investors are always trying to guess the future from statistics in the past, and that’s why IV can never be very accurate in predicting HV.

Note that IV and HV do not take stock jump direction into account. Even if investors are expecting a stock to jump downward, and increase the IV of the put option, the call option IV will also increase. You might notice put option open interest increase, however.

What is HV?

HV stands for Historical Volatility, and it refers to the amount that the stock is changing in price from day to day. The more violently a stock jumps around, the higher its HV will be.

Please note the important distinction that HV refers to the past, while an option’s IV is the same as the value that investors are expecting stock HV to become in the future.

Mathematically, 30-day HV is the standard deviation of the stock’s percent change over the last 30 days. See a complete derivation here .

You may click on the picture above to open it in full-size in a new window.

I have aligned the yahoo stock chart above with its 30-day IV and HV chart below. HV is shown in blue, IV in orange. Each of the vertical, green, dashed lines represent a day on which yahoo’s earnings were announced.

You can see that on Jan 15, 2006, the yahoo stock jumped greatly after earnings, causing a corresponding leap in the HV value. Conversely, the Oct 15, 2005 earnings announcment did not cause the stock to jump very much. Accordingly, the HV value stayed relatively low.

Please study the chart carefully until you understand the relationship between changing stock price and HV value.

Notice that HV is NOT related to the direction in which the yahoo stock is moving. If the yahoo stock jumps greatly in either direction, HV will increase.

Strangles

Many people have asked that I write an article about using strangles instead of straddles, so here it is .

It’s not as though I use them all the time … last earnings season I only traded one strangle. It was a good one, reaping 215% profit overnight on IN.

So, what’s a strangle? It’s the same as a straddle, except the call and put option are at different strike prices. As an example, let us imagine that MATK (a good jumper) is trading between strikes at exactly $42.50, since the closest available strikes are at $40 and $45.

In this case, I might like to analyse the purchase of the $40 put and the $45 call. Both options are out of the money, and their strikes are an equal distance from the current stock price.

There are two advantages for using strangles:

1. You have the opportunity to play earnings on a stock that is EXACTLY between strikes, giving you another type of ammunition in your trading arsenal.
2. You are buying OTM options, which are cheaper and tend to give a higher percentage return on investment when the stock makes a significant move.

It is extremely important to notice that advantage (2) is only applicable when the stock makes a significant move.

These are the disadvantages of using strangles:

1. Because the strike prices of the options are further apart, the strangle has a much wider “dead zone”. This means that the stock must jump much further before your position will break even, decreasing your probability of breaking even or better. Because they require a greater stock jump, less strangle trades will be successful. More will result in losses.
2. Because the options are OTM, you experience greater damage from falling IV. When a straddle may give you 30% risk, a strangle can easily give you 50% risk.
3. Strangles suffer more from time decay. Again, this is because the options are OTM.

There are more disadvantages, but I am making a new list so that I do not diminish the importance of the points above:

1. The spread can takes a huge chunk away from your strangle profits. You can often find a strangle costing $1.50 or so with a spread of forty cents!! Imagine that the stock jumps and your strangle increases by a theoretical 60%, up to $2.10. Taking away the spread, you will sell your strangle for only $1.70, or twenty cents more than you bought it.
2. Further, you will have to take commissions out of your profits. Imagine your losses if the stock had not jumped at all!

The effect of a bid / ask spread is compounded in straddles and strangles, because it can be double that of a single option.

Mirriam MacWilliams has taught you and I have demonstrated in the trading videos, that we must analyse our worst-case risk scenario before we consider our potential profits.

You must analyse the risk of your strangle in the following manner:

• Determine your worst-case likely IV drop from the IV / HV charts.
• Determine the stock-price at which your worst-case scenario occurs, which is exactly between the strike prices.
• Calculate the worst-case option prices, and see how much you are risking as a percentage of the position.

More often than not, you will find strangles are relatively dangerous to use. My calculated risk on the IN trade was 25% because of the exceptionally favourable IV / HV characteristics of the stock. Therefore, I did not take on exceptional risk to make the 215% profit.

Out of about ten possible strangles that I investigated in this last quarter, only one had the risk / reward characteristics that I was willing to accept.

VTS corporate action – follow up

Well, the VTS posting seemed to stir up a hornet’s nest … poor old Lewis from Wealth Mentors has a task bar full of blinking orange private messages from everybody asking for a second opinion. haha, sorry Lewis

Admittedly, I have been VERY tempted to trade VTS myself. And why not? It’s not exactly a risky trade, even if it doesn’t work out. In my opinion, you would be neither “wrong” nor “right” if you took the trade on, you just have a chance at having good fortune that the ‘chickens’ (like me) didn’t take.

If you’re interested in this subject, please take a good look at what has happened to KMI last quarter. You will see its stock chart leaped suddenly on May 30 (not earnings), and then stayed dead still at exactly $100. It had earnings a little later, on July 19, and the stock hardly budged from its $100 mark. I lost money on that earnings trade, haha, because I hadn’t learned to sense stocks that have some other factor overriding the effect of their earnings reports.

If you use this URL: http://briefing.com/GeneralContent/Active/Investor/TickerSearch/TickerSearchInvestor.aspx, you can type KMI in the ticker box on the left and look up the news events that happened to this stock on May 30 and later, on August 28. As you read through the news archive, investigate out how the news affected the stock price.

I’ll not spell it out for you in this article … better for you to look over the historical news and corresponding stock prices yourself. You can also type “KMI” into the left-most cell of a new row in trade alert to download a history of its jumps and earnings announcement dates.

You’ll find it very interesting to follow the story of how one takeover offer was made on May 30, and then another, higher offer on August 28. Notice how on August 28, the stock jumped up to a small distance below the actual takeover offer, and has slowly climbed closer toward that magic number as time goes by?

At all times, you will see that corporate news was overriding KMI’s earnings news and preventing the stock from jumping at the earnings announcements.

Is VTS in the same situation now as KMI was last quarter? I don’t know … but I’m dying to find out Isn’t this fun!

By the way, has anybody taken a position in VTS today? I’d love to see you leave a comment.

October blues

This is definitely an article that I wish I had written two weeks ago. You know I hate to write with the benefit of hindsight. But the topic of this article has been bugging me since early September, and this morning I dreamed that I had written the article and lots of people thanked me for it. So here goes.

Last quarter was a blinding success for the earnings strategy. It honestly seemed to me that almost any stock could be chosen and played without fear. Some newbies were learning dangerous habits. That’s because factors played directly into our hands:

• Pre-earnings options were cheap, and,
• The stocks were making record-breaking jumps

What a perfect combination for our strategy! Here are three out of many examples of stocks releasing tomorrow that made record-breaking earnings jumps last quarter:

	WCI	WYNN	RRD
Last Quarter % Jump	18.74%	12.60%	11.60%
Previous quarters	9.91%	7.83%	2.77%
	6.38%	4.16%	6.33%
	11.33%	9.45%	4.91%
	9.53%	8.84%	3.40%
	etc	etc	etc

Common sense shouts loudly that stocks cannot make record-breaking jumps every quarter!

Not only were the stocks making unbelievable jumps last quarter, but the options were also fairly cheaply priced prior to the stocks earnings announcements.

I believe that pre-earning options in general are not cheaply priced at the moment, and combined with smaller stock jumps, we are in the worst-possible position for the earnings strategy as we know it.

I like to think of the stock market as a windy place. Sometimes the wind blows in the direction favoring a certain style of trading.

Last quarter, the wind blew toward earnings and intra-day strategies. While we made huge profits in earnings and intra-day, people were experiencing difficulties with short-term and investing style directional trades. (Directional trades are trades where you buy either a call or put, and wait for the stock to move in a certain direction.) I told many people to stop their directional trades, and paper trade until the wind began blowing in that direction once more.

Right now, the wind is not blowing toward earnings. I have not traded live money for two weeks, and I recommend that you also do not trade live money until you start making decent profits in your paper trades.

I don’t know how long it will take for the wind to blow back toward earnings, but I do know this: Right now is the best learning opportunity the market will ever give you. Paper trade your way through this tough time and learn all you can. Work harder now than ever before. If you can make a profit or nearly break even in your paper trades this quarter, you will surely be rewarded when the wind blows your way again.

Trade the other strategies live and make some money. But if you don’t practice earnings now, you will definitely miss out when the wind changes direction. Wait and see!

A word to the newbies: Generally, the first thing you will ask for is a rule of thumb :) You will ask questions like “Does this happen every October?” or “How do we know what direction the wind is blowing?”, or “How long will it take for the wind to change direction?”

I don’t know the answer to any of those questions. All I know is that when the strategy becomes profitable again, I’ll be in there with all my cash, because I’m waiting, watching, and practicing, EVERY SINGLE DAY. How about you?
 

Corporate Action and Earnings

VTS is releasing earnings in a couple of days’ time. Before you go ahead and trade this stock, please take a moment, study VTS’s HV IV chart, and tell me what you think it means:

• IV has suddenly, unexpectedly, jumped well below its 52-week low.
• On the same day, HV  jumped up, telling us that the stock gapped hugely in one direction or the other.

Why was there an anomaly? Do take the time to consider what the chart is telling you.

---

There is more below, but don’t read it until you’ve had a little think for yourself.

• Yes, IV fell sharply because investors no longer expect the stock to move very much at all … does that make you think twice before you buy a straddle for earnings?
• Yes, HV jumped up because the stock suddenly gapped one way or another … probably due to a news event of some kind. (Check the stock chart for confirmation)
  • If the news event was earnings-related and the stock gapped, it means that the earnings uncertainty for this stock is high, and the stock will probably jump at earnings time later this week as well.
  •  If the news event was due to corporate action such as a takeover, merger, or acquisition, it may mean that the stock price will be frozen, ’stuck’ in one place from now on – that would be bad news for your earnings straddle.

I know after looking up the news for VTS that it is about be bought out by another, French company. But I don’t want you to walk away from this article without knowing how I knew the company was getting bought out, BEFORE even looking at the news. I want you to have the same deep level of understanding that rings your alarm bells at the right time, just by looking at the HV IV chart.

Since this is my first time in this type of situation, I am currently monitoring VTS to see how much it jumps after earnings. We will learn from this situation. I don’t hold the straddle, am much too conservative a trader for that, :) but I believe that the position would be very low risk anyway, due to low IV. IV really cannot drop any lower. If the stock does jump its usual 11% (and we don’t know if it will), with IV only 20%, you would make a huge profit.

Why  do I think the stock is not likely to jump?

The french company buying VTS has promised to pay $75 / share at the end of 2007, or in a year’s time. When the news came out last week, the stock price immediately leaped to $70 (check the stock chart), because the investors are now confident that the stock must be $75 at the end of next year. It’s like a sure thing!

Between now and the end of 2007, the agreement may fall apart. In this case, the value of the stock will no longer be fixed, and it will begin to fluctuate again. For now, however, while the agreement is still in place, the company’s earnings announcements won’t make much difference to its stock price.

Before you hang me for being wrong at the end of the week, please understand that I am writing this from the view point of going through this situation for the first time … we will have learned a lot more by watching VTS’s earnings announcements over the next year.

Do read the interesting conversation below, in which Gan and I slowly realized what was happening to the stock.

Gan

Hi! Ben,
VTS is due for earnings announcement on 4-Oct. Currently VTS’s HV & IV is quite far apart, with HV way above IV. IV is about 22%, and HV is 51%. IV is at lowest now. What volatility should be take for calculating worse case scenario? Any advise? Or may be it’s too early now, we should see whether the IV will go up more in days to come before earnings announcement.

Just thought this is quite interesting to monitor how it will turn out.

Gan

Benjamin Boyle

G’day Gan

Interesting little stock, isn’t it!

In my opinion, IV will definitely drop no further, so you have no IV risk at all. Well done on spotting that. There is a reason that IV is so low … investors are not expecting the stock to jump. Can you check the company news, and make sure it is not entering a merger or about to be acquired?

Historically, the stock is such a great jumper … what a conundrum!

Also check the news around where VTS made that huge gap around the same time IV fell down … see what caused that gap.

As far as I’m concerned, if the company’s options are not about to disappear due to upcoming corporate action, I’d try and get the $65 straddle as cheaply as possible when the stock is exactly on the strike. You have plenty of time before it announces to get a really good bargain.

The unusally low, and sudden change in IV should make you suspicious. But because of low risk anyway, I’d be happy to have a punt.

If the stock does jump, and there is no corporate action about to happen, IV will shoot up, (contrary to the belief that IV always falls after earnings) … potentially making your position more profitable than most.

Cheers / Ben

Benjamin Boyle

OK. I couldn’t resist. Looked up the news myself.

VTS is getting bought out. That’s why its shares popped up on 5th of September.

I have never seen this scenario before … I expect that the takeover news will squash any stock price jump, no matter how earnings turn out, since the company value has been fixed by the agreed take-over price.

Let’s watch and see

Gan

Yes, will see how this one develops, would be interesting to observed.

From the news:

“Massy, France-based CGG said it will issue $75 a share in cash or 2.25 of its American depositary shares for each share of Houston-based Veritas. The company said the offer, which will be paid out 51% in stock, gives Veritas holders a 35% premium over the stock’s 30-day average close. The offer also gives Veritas holders a 21% premium to Friday’s close of $62.18. ”