Here is what a trader did on the 20th Dec as reported in ET:
Just bought NKE Jan 100 straddle for debit of 5.82. Option prices seem relatively cheep (sic) considering its right before earnings announcement. Any ideas on how it might play out? All comments are welcome!To which one of the experienced hands replied:
Learning exercise....and that is exactly how it played out.
Go to www.ivolatility.com and enter NKE in the ticker symbol location. Then look at the chart for historical IMPLIED VOLATILITY. Then compare where the IV is today for NKE compared to where it has been a few weeks ago.
To cut to the chase, current IV is at 25% or so. Last month it was at 16%. The high for the year is 28% last December (presumably before earnings) and the low is just under 16%.
So you are buying a straddle when IV is near historical highs.
In December of last year, IV crashed from its high of 28% or so to about 18%.
So what does this all mean. High IV means premiums are higher in value relatively. When earnings are released IV crushes. So your straddle will most likely go from an IV of 25% to somewhere below 20%. If you are not sure what that means, plug your straddle in an option calculator and change the IV from 25% to 19% and see what happens to the value of your straddle. It will drop sharply.
So before putting any money into a straddle you should study volatility and the effect it has on option prices.
Basically with respect to volatility you are buying high and gonna sell low after the news. So you need a real nice stock move to overcome the volatility crush AND time decay that will start creeping in...
The poor guy bought the straddle on the 20th for $5.82 with the underlying at ~$100.00. Today with the underlying still ~$100.00 the straddle is worth about $3.60.
What happened? Implied volatility crush; which often happens once earnings are released... and if the stock doesn't move, or it doesn't move *enough, the trader gets smacked on long gamma positions (bought option positions like straddles).
This is what is termed "vega risk", the possibility that implied volatility will drop on your bought options (or rise on your short options) and cost you money, independent of any stock price movement.
The flip side of the coin is that it can also work in your favour. The trick is in understanding it as a risk when entering positions.