• 287 days Will The ECB Continue To Hike Rates?
  • 287 days Forbes: Aramco Remains Largest Company In The Middle East
  • 289 days Caltech Scientists Succesfully Beam Back Solar Power From Space
  • 689 days Could Crypto Overtake Traditional Investment?
  • 694 days Americans Still Quitting Jobs At Record Pace
  • 696 days FinTech Startups Tapping VC Money for ‘Immigrant Banking’
  • 699 days Is The Dollar Too Strong?
  • 699 days Big Tech Disappoints Investors on Earnings Calls
  • 700 days Fear And Celebration On Twitter as Musk Takes The Reins
  • 702 days China Is Quietly Trying To Distance Itself From Russia
  • 702 days Tech and Internet Giants’ Earnings In Focus After Netflix’s Stinker
  • 706 days Crypto Investors Won Big In 2021
  • 706 days The ‘Metaverse’ Economy Could be Worth $13 Trillion By 2030
  • 707 days Food Prices Are Skyrocketing As Putin’s War Persists
  • 709 days Pentagon Resignations Illustrate Our ‘Commercial’ Defense Dilemma
  • 710 days US Banks Shrug off Nearly $15 Billion In Russian Write-Offs
  • 713 days Cannabis Stocks in Holding Pattern Despite Positive Momentum
  • 714 days Is Musk A Bastion Of Free Speech Or Will His Absolutist Stance Backfire?
  • 714 days Two ETFs That Could Hedge Against Extreme Market Volatility
  • 716 days Are NFTs About To Take Over Gaming?
How Millennials Are Reshaping Real Estate

How Millennials Are Reshaping Real Estate

The real estate market is…

Another Retail Giant Bites The Dust

Another Retail Giant Bites The Dust

Forever 21 filed for Chapter…

How The Ultra-Wealthy Are Using Art To Dodge Taxes

How The Ultra-Wealthy Are Using Art To Dodge Taxes

More freeports open around the…

  1. Home
  2. Markets
  3. Other

The Anatomy of an XOM Earnings Trade

One of the most interesting aspects of options is the myriad opportunities presented for high probability trades for those who understand the details of option behavior.

For example, I have recently discussed the routinely observed collapse of implied volatility immediately following an earnings release. We have looked at several examples of profitable trades constructed to benefit from this expected decline in implied volatility.

Today I would like to review another group of trades based on a fundamental characteristic of option pricing. In order to understand this phenomenon, we need to review briefly the anatomy of the price of an option.

Remember that an option's price, while quoted as a pair of bid / ask values, is in reality the sum of two components. The current market price is the combination of the extrinsic and intrinsic components of the individual option contract.

The extrinsic component can comprise the entirety or only a variable portion of the market price of an option. All options contain at least a small amount of extrinsic component.

The intrinsic component of an option may comprise the majority of the value of an option, as for example a deep in-the-money option. Conversely, an individual out-of-the-money option routinely contains no intrinsic value whatsoever.

As an example, consider two current option prices from the AAPL option chain as the price of the stock is around $450. The deep in-the-money March 400 call is priced at $54; it consists of $50 of intrinsic premium and $4 of extrinsic premium. In contrast, the out-of-the-money March 500 call is priced at $2.60. It contains $0 of intrinsic value and $2.60 of extrinsic premium, or the entire price of the option.

One important consistent observation on the ratio of these premiums should never be forgotten because it is invaluable to remember in constructing potential trades. The at-the-money option contains the most intrinsic premium within any one expiration series. This occurs 100% of the time or ALWAYS.

Another important point to realize, another characteristic about which there is no argument, is that the extrinsic premium goes to essentially 0 at expiration. Furthermore, there is a rapidly accelerating decline to 0 as the expiration date approaches.

My mental analogy is that the extrinsic premium is like a snowball rolling downhill; it starts slowly, gains mass, and rapidly accelerates as the end of the slope (the expiration date) approaches.

While in previous times this vanishing of extrinsic premium was confined to a single monthly cycle, the recent advent of weekly option cycles has come to mean this is a weekly event. The final smell of burning extrinsic option premium as it goes to 0 occurs every Friday for the most active issues!

The logical extension of this daily decay of extrinsic premium has a practical implication every Friday morning. Extrinsic premium that is present for options series expiring that day will go to 0 by the closing bell. Read that again! This weekly occurrence has great profit potential for your trading.

As an example of the power of this mandatory decay, let us consider last week's closing action in the XOM weekly option series. As we have discussed before, XOM has a hugely active options series, trades in both monthly and weekly expiration series, and has bid / ask spreads that are just a few pennies wide. It is, in short, close to an ideal option trading candidate.

XOM reported earnings shortly before market open on Friday, February 1st. The stock initially sold off to $89.40 from its previous close at $90.24. Shortly following this bottom, the stock manifest an intraday rally and the option activity was tightly focused within the first hour of market activity at the 90 strike options which were to expire that day.

02/01 XOM Intraday Price Chart
02/01 XOM Intraday Price Chart

02/01 XOM Option Chain
02/01 XOM Option Chain

This strong, clear, and tight focus of options activity was a highly predictive factor that XOM would "pin" the 90 strike for the day.

At the time that XOM was slightly below $90 and the extrinsic premium existing in the 90 strike puts contained an extrinsic value of $0.28 and a total price of $0.32. I sold the 90 puts with only a few hours of life remaining until expiration. Within a few hours, XOM traded to a few cents above $90 and I was able to close these puts for $0.12.

This highly successful trade benefitted from both the resurgence in price correctly predicted earlier by the tightly focused options activity at a single strike price and by the relentless decay in extrinsic premium toward 0 as the expiration bell approached.

 


Simple ONE Trade Per Week Trading Strategy?
Join www.OptionsTradingSignals.com today with our 14 Day Trial

 

Back to homepage

Leave a comment

Leave a comment