An Interesting Note

An Inside Look Into My Tactics

By Bryan Bottarelli
Wednesday, December 20, 2006 12:49 PM EST
Wed, 20 Dec 2006 17:49:00 GMT

Dear Bottarelli Research Member,

I received a very interesting note from Charter Member G.N. today concerning the pricing of our FedEx puts — and I’d like to share his note with you. George writes,

“Bryan: Good trades! Thank you. I noticed the ivolatility.com’s option calculator registered a much higher theoretical value for our puts trading at the levels we saw this morning. I showed pricing for the puts to calculate about $1 higher than we saw ($6.50+), and the implied volatility calculator showed volatility to have almost doubled since yesterday’s close! So a higher price would have been expected. Can you explain this? Why such a discrepancy? I would enjoy it if you would shed some light to us subscribers”

This is a great question — and one that many option traders struggle with. You see, G.N. noticed that FDX stock was down this morning — so he used an options pricing calculator to see what our FDX puts would be worth at the open of trading. But the calculation that he received came out to be less than what the actual FDX puts traded for at the open. How could this happen, you ask? Here is my response…

“Hi George, you are right on the money. Implied volatility is, by far, the most ambiguous of the option pricing metrics. But here is what I have noticed. When you have a company, like FDX, that is leading up to an earnings announcement, you know that one event (the earnings) will cause a big move in the stock…either up or down. As a result, both the calls and the puts have high levels of volatility priced into them leading up to the announcements. Then, after the announcement is made, the unknown factor (aka, which way the stock will move) is now a known factor — which in turn causes the pumped up volatility levels to decrease. As a result, your options move based on the actual stock movement — but at the same time — the juiced up volatility levels are decreasing.”

In other words, floor traders pump up the volatility levels in both the calls and the puts leading up to an earnings announcement. And once that announcement has been made, the volatility premiums come down. I know this because I used to be in charge of altering the volatility levels on Apple Computer (AAPL – NASDAQ). In the days leading up to an earnings announcement, I would raise the volatility levels — thus inflating the prices of both the calls and the puts. And the moment after the earnings announcement, I would lower the volatility levels of both the calls and the puts. Not many individual traders are aware of these events — and that’s why I tend to utilize certain trading strategies here in BottarelliReseaerch that capitalize on these events. For example, allow me to continue in my response to G.N…

“In many respects, that’s why I tend to sell calls and puts the day before earnings announcements — because I know we can capitalize on high volatility levels even before the earnings are announced. Sure, we may miss a big move in our favor, but consistently taking gainers prior to earnings is a good long-standing strategy….with less risk!”

You’re probably wondering why I decided to share this email exchange with you. The reason, other than to let you in on a little floor-trading secret of pre-announcement volatility tinkering, is to highlight the current situation in the very stock that I used to alter on the CBOE floor, Apple Computer (AAPL – NASDAQ). Check out the chart:

AAPL

As you can see, AAPL stock has come right back down to the 50-day moving average at $85.00. Looking at the 5-month chart, this is a very strong support level. At the same time that AAPL is finding near-term support, the company is scheduled to report earnings on January 17th. So perhaps, if the timing is right, we can play call options leading up to their mid-January earnings and sell them for profits into the increased volatility levels just before they report their number. The ideal time to make this play is in early January, after the lull created by the upcoming market holiday. So stay tuned — when it’s time to make a play, you’ll be the first to know. Until then…

Lock and load!

Sincerely,

Bryan Bottarelli

Bryan Bottarelli
Editor, Bottarelli Research

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