Volatility check

Earnings season can offer opportunities to traders who like to buy dips, since negative surprises can trigger significant sell-offs, some of which may turn out to be overdone, at least in the near term.

Aside from the risk that a stock will keep falling after such a move, options traders who attempt to take advantage of these moves face another strategic hurdle.

For example, on Tuesday, Phathom Pharmaceuticals (PHAT) fell nearly 25% intraday, extending the stock’s loss since its November 7 earnings release to nearly 47%:

For the sake of argument, let’s say a trader thought the move was overdone and wanted to take a long position in anticipation of a rebound that could unfold over the next week or two. But wanting to avoid the downside risk of a stock position, the trader was leaning toward buying call options.

In this case, the at-the-money December $10 was certainly priced at a discount on Tuesday morning, trading at 1.90 ($190)—down more than 76% from its last recorded price of 8.00 ($800) from November 1, when the stock closed at $18.27.

Unfortunately, there was a chance the discount on the call wasn’t as deep as it appeared to be. A check of the LiveAction scan for 52-week high implied volatility (IV) showed PHAT near the top:

Implied volatility is the market’s estimate of a stock’s future (in this case, 30-day) volatility, which is baked into the options price. One way to think of it is that the higher IV is, the more uncertainty there is about the stock’s future price level—and that uncertainty often translates into option prices that are higher than they would be otherwise.

In a situation like this, that can mean even if the stock rebounds, a long call position may not gain as much as a trader had expected because IV will likely decline. And just as high and/or rising IV inflates options prices, low and/or falling IV deflates them.

There are a couple of ways traders can try to get high IV to work for them instead of against them. First, they can short options (e.g., selling puts instead of buying calls), which could benefit from falling IV, but also risks losses if the stock continues to fall. Second, they could combine short options and long options. For example, instead of simply buying a call, a trader could create a bull call spread by adding a short, higher-strike call with the same expiration date. Unlike the long call, the short call stands to benefit from falling IV, as well as time decay.

Market Mover Update: Floor & Decor (FNC) topped the LiveAction scan for high put-call ratios on Tuesday. With its stock down mostly between $102-$104, 5,800 of the January $90 puts (more than 10 times the existing open interest) changed hands.

Today’s numbers include (all times ET): Consumer Price Index (8:30 a.m.).

Today’s earnings include: Dole (DOLE), Beazer Homes (BZH), Cisco (CSCO), Helmerich & Payne (HP).

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