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The 6-Week Options Trading Kickstarter: Options Pricing Basics

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Steve Smith breaks down the basics of options pricing.

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We'll use Fusion-io (NYSE:FIO) as an example.

Fusion IO, ahead of its April 24 earnings report, saw implied volatility climb up to 90%, which was well above the 52% rate at which the 30-day HV was running at this time. This was because the options market was pricing in the 10% price move that the shares had averaged over the past four earnings reports. The stock responded to the earnings with a 7% decline to $26.20. Immediately following the report, IV declined to 55%, or right back to the HV.

This type of drop in implied volatility is quite common following an earnings report or any scheduled event that has market moving implications. In this case, the combination of the options having overpriced the expected move and the post-earnings premium crush means that the value of puts did not go up much despite the drop in stock price. For example, the May $25 puts only gained $0.20 to $1.80 on the day after the earnings report.

An increase in implied volatility ahead of an event is simply the expression of a higher probability of a larger-than-usual price move within a given time frame. In this sense, an increase in implied volatility is an artificial expansion of time. In other words, what could happen over a long period of time is now being priced into a shorter period of time, and that makes sense ahead of a volatility-inducing earnings report.
No positions in stocks mentioned.

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