Why Pre-Earnings Options Pricing is So Imprecise

Our streak of days with high-profile earnings gaps ended at one yesterday, as Apple Inc. (NASDAQ:AAPL) had a relatively calm reaction to its usual stellar numbers. The options priced in about a $4 move, and the actual opening gap was about half that.

There was a long volatility "win," however, as The Coca-Cola Company (NYSE:KO) -- of all names -- was a serious disappointment. It wasn't the biggest score ever, though, for the options owners. The board priced in about a $1.20 move, and in actuality it gapped down about twice that.

All of which leads me to realize I better refresh what it is we're talking about here.

As we all know, most stocks tend to react to their earnings reports. Options anticipate those gaps via elevated implied volatility (IV). The trick is to estimate the degree of volatility "bid-up" and translate that to expectations about the earnings reaction. But, it's not so simple, as there are other drivers to options pricing. The entire world saw a big volatility bid-up recently, so how can you tell what was Ebola fear, for example, and what was anticipation of earnings?

The answer is that you can't do it with any certainty, but you can make educated guesses. The nearer the option to expiration, the more it's moving in relation to the expectation of a post-news reaction. Conversely, the further from expiration the option, the closer the IV is to the true mean volatility. So, to produce an estimate, you would have to translate the volatility curve into a percentage move in the stock.

Simple, right? Well, you don't really have to do the math yourself anymore, as most trading systems will calculate this number for you. With ThinkOrSwim, for example, you can find the number on the Trade Screen under "MMM."

Let's use AAPL for an example. The MMM was about 4, and the stock was in the 99s. That says that based on the IV curve, the options are pricing in a move of modestly greater than 4% the next day. That number is a standard deviation, so as such, it really says that there's a roughly two-thirds chance that AAPL moves within a 4% range, and a roughly one-third chance that it moves beyond the range.

Obviously, each stock has a sample size of one reaction, so it's best to view them all as one big package of numbers. And, if options are more or less pricing reactions correctly, about two-thirds of the names will settle within range of their expectations, and about one-third will move beyond those expectations and squeeze the options shorts.

Thus, when you see a Netflix, Inc. (NASDAQ:NFLX) and an International Business Machines Corp. (NYSE:IBM) and a KO move way beyond the numbers, it doesn't mean those quoted options numbers were wrong. Rather, it's expected that many numbers will miss -- a full one-third of them, in fact.

It's also unlikely that every given earnings season sees a perfect two-thirds and one-third split -- it's a dynamic process. If names keep missing, options prices will lift on the next batch of earners, and so on, until prices rise enough. And, of course, the same thing happens in reverse if everything is moving in line.

It's also improbable that these reaction estimates are exactly correct. An algorithm can guesstimate how a volatility curve will look after earnings, but it can't guarantee it. Perhaps longer-dated options carried more earnings premium than normal, or less premium, or whatever -- the point is, it's a guideline and not gospel.

Oh, and one final point. It's all a zero-sum game. Just because selling earnings volatility is likely to win two-thirds of the time, it doesn't mean it's going to work. The potential losses on those shorts are open-ended, whereas the wins are defined, as you can't earn more than the premium you take in. One NFLX can wipe out a lot of AAPLs.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.