So just some thoughts on volatility contraction ( or crush ). One of the inputs to option pricing models is something called ‘volatility’. This is the only unknown input into option pricing formulas. It is a prediction of how volatile the stock WILL be in the future. Since we do not know what the future price of the stock is, this volatility is a ‘guess’.

I want to use Michael’s BIDU call as an example. Michael Trader bought a Mar08 250 Put. Today it closed at $21.50. Since the put is out of the money, the price is heavily influenced by the pricing model which is determined by the future volatility, or rather the guess of the future volatility.

So what does this mean for the price of Michael’s put ? BIDU’s earnings were after the close and they came inline with expectations. Well, since during the trading day, we could not predict what the earnings would be ( or what the market reaction would be ) traders charged a higher premium ( higher volatility ) to sell options to cover their a$$’es in the case of a huge move. So now after earnings, option sellers would not charge such a high premium for options.

So after earnings, even if the stock price does not change, the price of the option will probably fall. There are lots of other things that could happen, but I would not go into those here. We can expect , all things being equal, Michael’s put opening lower. Sometimes the volatility crush can be huge, sometimes not that great. But that is the nature of trading.

And to Michael , dude, we have all been there. Good luck.

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This entry was posted on Thursday, February 14th, 2008 at 7:19 am and is filed under Option Trading.