Skyworks (SWKS): Stock Up, Volatility Down

New traders can sometimes be disappointed when they buy a call ahead of an earnings report. What if the company reports great earnings, the underlying stock moves higher, and the calls either break even or lose money?

Earnings can be bullish or bearish catalysts for a stock and they can sometimes create abnormal daily movements in a stock’s price. For example, Skyworks Solutions (NASDAQ: SWKS) reported revenue of $238.1 million and non-GAAP earnings per share (EPS) of 24 cents for the second quarter. Analysts were expecting revenue of $232.2 million and EPS of 23 cents.

SWKS also guided higher for the next quarter, higher than analysts had expected. In addition, Kaufman Bros initiated coverage on the equity with a “buy” rating it, giving Skyworks additional bullish support. The shares traded 6.5% higher on Friday to $17.26, much more volatile than a typical daily move for SWKS, but implied volatility (IV) is trending lower.

In the options markets, a sharp move higher after earnings become public knowledge typically means that IV is on the decline. Why? Because the market now has access to data that was previously unknown. Thursday, ahead of the report, IV in SWKS June options was right around 50% for the at-the-money strikes. Friday midday, that number was around 36%, a 14% absolute drop in IV.

So why should you care?  When investors purchase options (i.e., go long), they are getting long vega, which means a positive bias to volatility. The July 17.50 call, for example, has a vega of 0.026, which means that for every 1% absolute change in volatility, that option is going to increase or decrease approximately 2.6 cents in value.

So the 14-point reduction in IV we saw in one day in SWKS would translate to almost a 37-cent drop in the options price, or $37.00 per contract. If the delta of that option was 0.40 yesterday and the stock only moved up $1.00, traders long these options may only realize a three-cent profit (and that doesn’t account for any time decay or commissions).

Even though these calls would make 40 cents on the delta, they would lose 37 cents on the vega. At-the-money options typically have the highest vega, so use caution when buying options ahead of an event such as earnings. Also remember that the risk to buying a long call is 100% of the premium paid.

Of course if the underlying stock makes a very large move, option traders can increase their chances of being correct in a long call trade, but that success is not assured. If the stock were to drop and traders are long puts, for example, volatility may actually increase, which would be beneficial to the long positions.

There is no way to tell exactly which way a stock will move over earnings, just bear in mind the effects of implied volatility and vega when selecting earnings strategies. For the most part, the time immediately following earnings comes with a short-term move lower in implied volatility.

Photo credit: James Cridland

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