We are looking at a theoretical example in Micron (MU). Let’s assume that MU will report earnings next week after the market closes on August 5th. Even though Implied Volatility is currently extremely expensive, it most certainly will move higher as we approach earnings.
So, a thought process might be, why not buy volatility now if it’s going to move higher by next week? We first must understand what changes an option price as volatility moves. That “Greek” is known as Vega. Vega measures the change in the value of an option with a 1% change in Implied Volatility.
For example, if the Implied Volatility of the MU September 21st expiration, 42 strike call is 74.29, which can be seen below, and its VEGA component is 2.62, then the value of this option will change by $.0262 when the implied volatility changes by 1%.
So if the implied volatility rises by 6 points to 80.29, then the value of the option will rise by $.1572, (6 x $.0262). Conversely, if the implied volatility decreases by 10 points to 64.29, then the value of the option will decrease by $.262, (-10 x $.0262).
Again, if we believe that implied volatility is going to rise by next week, we should buy it now, right? Not so fast. This is where one of those other “GREEK’s” comes into play. Theta measures the amount of premium or time decay that decreases the price of an option daily. The THETA of this option is $.11, which means that this option will lose $.11 daily due to time decay. One additional characteristic of THETA is that it is not linear, meaning that an option does not decay the same amount each day. It actually increases by a greater amount the closer to expiration it becomes. But, for example purposes, let’s say that the September 21st, 42 strike call did decrease by $.11/day due to theta. Then looking ahead the earnings report after the market close on September 20th, that would be 8 days of premium decay or a decrease in the value of this option by $.88, (8 x $.11).
As you can clearly see, the price decrease due to theta decay can far outweigh the projected rise in implied volatility that we expect to see leading up to earnings.