Back in the good old days of a VIX priced at $10, I used to talk of volatility on a weekly basis. I was doing my part to take advantage of the conditions and school those around me as to what would happen when the VIX started to take off and test multi-year highs. I spent a lot of time (check my archives) talking about implied volatility, because it is in a close race with "price" to be considered as the most important factor in the pricing of an option.

We all know that this earnings season has definitely been the toughest in years. Not to mention, I am sure you have had just as much of a colorful experience as I have had, holding a small number of contracts over many earnings announcements. I have heard many people comment on the fact that prices have gone in the favor of the position, but the price of the option barely moves, or even creates a loss. This is all part of the volatility collapse that happens over earnings.

As I was doing my morning "charts" routine, I stumbled across Lam Research (LRCX). I remembered a monster trade I had on this stock back in 2005, and many of you that remember my evening presentations that far back will remember that this was one of my top 10 trades of 05.

Anyway...I looked at the positive response it had to its earnings report (up 10%) and then noticed the massive implosion that occurred in the average implied volatility...

As you can see, the average IV dropped off 14 percentage points. That is like a stock losing 26% of its value. Notice how IV had steadily increased over the last month leading up to this event. Generally speaking, this is what happens to options during earnings season. The expectations start to increase long in advance of the announcement. This is why I hate to buy them just before the announcement. The added expense kills your probability of a successful trade.

I think that in order to really understand the effect that the lost volatility has on the option, you need to see the numbers...

Let's use yesterdays values...

Strike: $35

Stock: $31.59

Days: 17

Volatility: 54%

Interest Rate: 1.67%

Theoretical Call Value: $0.41

Actual value (Last nights close): $0.55

Now here are today's values...

Strike: $35

Stock: $33.80

Days: 16

Volatility: 39%

Interest Rate: 1.67%

Theoretical Call Value: $0.64

Actual Value: $0.75 ask

These values changed quite a bit since I observed them. The stock has continued to run up to $35, causing the calls to increase even more, but the example I used will hopefully give you an idea of how this works. Even though the stock opened with a 5% gain, the value of the calls only changed slightly. These values don't account for slippage that would occur, or wider than normal bid/ask spreads.

Be careful holding over earnings.