Research In Motion (RIMM) reported disappointing earnings Wednesday after the bell, and the stock dropped. But it wasn’t exactly a free fall. By Thursday morning, RIMM was trading around $70, a roughly 4-point drop from Wednesday’s close of $73.97, or about a 5.5% decline.
Yet a funny thing happened: If you owned RIMM put options, they didn’t necessarily increase in value, especially if you owned April puts with a strike in the 70s or lower.
Say what?
Yes, that’s right, you owned puts, the stock took a considerable, albeit not catastrophic, tumble, and you lost money.
Quick, who do we blame? RIMM options market makers? The CBOE? Goldman Sachs? Geithner and Bernanke?
Nope, how about the far-less sinister sounding “normal drop in options volatility after a news event.”
Let’s say you have a stock with an anticipated news event, most often that means earnings, but a biotech company with an FDA ruling fits the bill too, as do countless other examples. You know there is a significant probability of a gap move on tap, so it pays to “over-bid” for options before the news comes out. That translates into a volatility spike on the options board.
Here’s the way the RIMM volatility chart representing the past six months looked before earnings:
The yellow line shows the implied volatility (IV) of an option with constant 30-day duration. As you can see, it carried a volatility in the high 40s.
Compare that to the blue line that represents 30-day historical volatility (HV) — or how RIMM’s volatility actually behaved — and that had dropped to near 25.
Now, 30-day HV is not a great measure of the stock volatility traders right now feel. It’s not even comparable in time to 30-day IV, as IV measures in calendar days and estimates future volatility, while HV is a look backward and measures in trading days.
I prefer 10-day and 20-day numbers. It’s noisier, but more representative of how the stock actually feels now. So here’s the 10-day HV in RIMM for the past six months:
RIMM itself moves at about a 30 volatility pace on average by this measure, too, which makes it pretty clear that options volatility in the high 40s is unsustainable, much less volatility in the high 50s in the April options.
Typically once the news hits, options volatility will get smacked. In RIMM, for example, we could safely say that traders won’t pay for more than a mid-30s volatility with no news pending.
So this brings us back to the odd situation we described above in the April 70 strike puts. They closed Wednesday at a 58 volatility, then traded at a perfectly justified low 30s volatility on Thursday. The results was that this volatility drop pretty much offset the directional “win” of owning puts in the ugly stock when translated into the actual put prices.
Related Articles:
- RIMM Implied Volatility Gone Bad
- 4 Cheap Option Trades on Expensive Stocks
- Why Does My Call Decline When the Stock Gains?
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