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
UNH: Price Chart Before & After the 4/14/2022 Earnings Release
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.
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Alan,
I am interested in using your ultra safe delta and implied volatility approaches to picking strike prices. Will using a 16 delta usually be the same strike as using implied volatility?
Thanks for all your great information.
Chris premium member)
Chris,
Extremely close but not always precisely the same.
I actually did a study evaluating the 2 parameters using >100 stocks and ETFs and over 60% came to the same strike. The rest were the next strike available. Keep in mind that not all securities have options with 16 Deltas.
Using either metric will work well, or you can use both for confirmation.
Alan
Hi Alan,
The discussion around UNH was fascinating – thanks for highlighting it. I’d like to add that IMHO in this case the fact that the call was purchased ATM was also a significant contributing problem.
Why do I say that? Let’s ask ourselves why did Kevin go long call 3 days before the earnings? He must believe that underlying would pop leading up to or after the earning announcement and he’d close his position after that. As the underlying rises in price and the strike moves deeper in the money (for UNH case) the delta falls, too! Ergo, had the call been purchased out of the money then in fact leading up to and after the earnings announcements the rise in Delta would have compensated (somewhat) for drop in Vol. This IMO is true even though OTM options cost more – since the IV is higher out of the money (when the option was written) as it would have been made up by rise in Delta as the underlying rose if the bet is correct. By going long call ATM all one achieves when underlying rises is to convert the extrinsic value into intrinsic value – which unfortunately for Kevin, in case of UNH, quickly evaporated as the underlying crashed due to secular reasons.
Do you agree?
Best,
Alok
Alok,
From time to time, many of us (including me) have a tendency to over-analyze a trade. Let’s break down this trade from another perspective.
When Kevin purchased the ATM $540.00 call, he paid a higher time-value cost than if he purchased an ITM or OTM strike. ITM strikes would have cost more overall due to the intrinsic-value component which ATM and OTM strikes do not have. He needed to overcome a time-value debit of $13.85 per-share to have a successful outcome.
This makes the breakeven price point $553.85 less any time-value component of the premium which was subject to the volatility crush described in the article and Theta.
Can Delta overcome Theta and Vega? It’s true that if share price accelerates, as Kevin anticipated, Delta will increase as the $540.00 strike moves deeper ITM but it’s still a David versus Goliath proposition.
For this trade to be successful, UNH would have had to accelerate in price to a much greater extent than it did. The report was favorable and share price did rise but the entire call price was lost. Kevin was correct in his assessment of the ER but lost money due to the structuring of the trade around and ER and the subsequent decline in the overall market.
In the BCI methodology, we learn from our wins and our losses. If we lose money, we ask ourselves how we could have done better and never make the mistake again. I felt this trade offered excellent educational value.
Alan
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Alan,
I wondered if you could answer the following question.
Assume I have a covered call in action. Expiration is due soon. It’s ITM. Better to buy to close or just let it expire ? Do I get the extra money between the market price and the strike price ?
Thanks. Malcolm – a novice !
Malcolm,
The decision to close the short (covered) call or allow exercise and have our shares sold depends on whether we want to retain or sell the shares. The financial aspect is about the same in both cases.
Let me set up a hypothetical example:
Buy 100 x BCI at $48.00
Sell 1 x $50.00 call at $1.50 (we keep $150.00 per contract either way)
As expiration approaches, BCI is trading at $52.00
If we allow exercise, shares will be sold at $50.00, resulting in a total per-share profit of $3.50 ($1.50 + $2.00)
If we buy back the option, the cost will be the intrinsic-value of the premium (amount the $50.00 strike is lower than current market value ($2.00, in this hypothetical) + a very small time-value component (since the contract is about to expire), say $0.10. The cost-to-close is $2.10.
If we allow exercise, we get paid $50.00 per-share but if we close the short call, our shares are worth (at that point in time) market value or $52.00 for an unrealized gain of $2.00. This means that the actual time-value cost-to-close is $0.10 per-share.
Bottom line: If we want to retain our shares moving forward, close the short call before expiration. Otherwise, allow exercise. The monetary aspect is about the same.
Alan