Why Did Option Value Decline After Stock Price Accelerated? A Real-Life Example with United Health Group Inc. (NYSE: UNH) – November 07, 2022
We, as covered call writers and sellers of cash-secured puts, are on the sell-side of options. Every so often, I receive interesting emails with educational value from members who buy options. On 4/21/2022, Kevin shared with a trade he executed with UNH where share value went higher after purchasing a call option, but the value of the option declined significantly. This article will analyze the trade and explain why such a scenario actually does make sense in certain situations.
Kevin’s UNH trade history
- 4/11/2022: Buy 1 x 4/29/2022 $540.00 at-the-money (ATM) call at $13.85 (UNH trading near $540.00)
- 4/14/2022: UNH reports earnings and share price rises up to $545.00
- 4/21/2022: Kevin writes me asking me about the significant decline in option value despite the rise in share price
- 4/29/2022: UNH price suffers from an overall market decline causing the $540.00 call to expire worthless or with no intrinsic-value
Graphic representation of the UNH trade
Option Greeks: Factors that impact option value
- Delta: Time-value change in option value for every $1.00 change in share price
- Theta: Time-value erosion for the passing of every 1 calendar day
- Vega: Change in option value for every 1% change in the underlying’s implied volatility
In this case for UNH (post-earnings), Delta is causing an increase in premium, but Theta and Vega are forces in the opposite direction. The main factor in this scenario is Vega and the resulting volatility crush.
What is volatility crush?
This is where the implied volatility of options accelerates exponentially prior to an earnings report due to the uncertainty of that release and subsequently drops precipitously once earnings and fundamental information are made public.
Discussion
The call was purchased 3 days prior to the 4/14/2022 earnings release when the volatility of UNH was through the roof (technical term?). As a result, a high time-value premium was paid for the call. Post-earnings release, the volatility dropped significantly as did the time-value of the call option. Moving forward, the time-value will continue to decline due to Theta and volatility would be expected to remain in a tight range. If the call is retained, the hope is that Delta will compensate for the volatility crush if share value rises, and intrinsic-value makes up for loss of time-value. If the call is sold, it will be at a loss, but at a less painful loss if share value remains the same or declines (as it did). Buying call options prior to earnings and sold after earnings puts traders at a time-value disadvantage.
In our BCI methodology, we are on the sell side of options and avoid earnings reports.
Author: Alan Ellman