With credit to Lemony Snicket, these events may or may not be “unfortunate,” but the option activity these days is being dominated by upcoming events -- mostly FDA hearings and drug trial results. Of course, earnings announcements are also mixed in there. We discussed this topic just three issues ago, but these event-driven stocks have dominated option trading more than usual this week, so we’re going to follow up with an update on what’s happening in this arena.

Event-Driven Trading
We can often tell when a stock is about to experience an “event,” because a) its options suddenly get very expensive and / or b) a large skew develops in the options -- typically a horizontal skew, where one month’s options are more expensive than the rest. Many times, it’s difficult to determine why the options are expensive and / or skewed, but, if the condition persists, you can bet the reason is valid.

Usually, the option market does its best to estimate how volatile the event will be and to price the options accordingly. However, this is an arduous task that really can’t be executed with any firm degree of accuracy because of the vagaries involved when the news becomes public. To illustrate this, how many times have you seen a company announce earnings that were in line with analysts’ expectations, only to see an “extra” little negative announcement about earnings or sales forecasts cause the stock to tank suddenly.

The best information had gone into pricing the stock and the options in line with the expected earnings. Even though those earnings did materialize, the stock price had to adjust to the new information. The same things happen even more dramatically in the case of drug trial tests and FDA hearings.

How can one possibly predict the price of an option whose underlying stock is about to undergo a dramatic move as a result of one of these events? It is difficult and is perhaps more of an art than a science. But, here’s a simple example to show how it might work.

Example: Suppose that these facts are known:

1. XYZ is due to announce trial results of an important drug it's been working on.

2. The stock is trading at 50.

3. The announcement is due tomorrow, and the near-term
options have three weeks of life remaining.

4. The stock normally trades with 60% volatility.

What should be the price of the near-term call?

To estimate this call’s price, a trader or market maker needs to estimate where the stock will trade if the announcement is positive or negative and what the probabilities of the event are. In this case, suppose we feel that poor test data will cause the stock to fall to 46 (perhaps expectations are muted for passage), but a positive result will cause the stock to jump to 56. Moreover, we assign a 40% chance of poor results and a 60% chance of positive results.

Using the Black-Scholes model, we can price the call if the stock is trading at 46 or 56:

Now, we apply our probability assumptions -- 40% chance that the stock is at 46 and 60% chance that it’s at 56:

Blended call value = 0.4 x 1.22 + 0.6 x 6.98 = 4.68

(As an aside, the companion put would be selling for approximately 4.60, making the straddle price 9.28.)

So, if -- on the day before the event is announced -- XYZ is trading at 50, and the 3-week call is selling for 4.68, that’s an implied volatility of 97%!

Taking this out to the next month, the 7-week call would be worth 2.54 with the stock at 46 or 8.33 if the stock is at 56. Blending those values, we get a value of 6.01, which would be an implied volatility of 82% with the stock at 50 today.

So, you can see that both options are expensive (compared to the “normal” volatility of 60%), and a natural skew develops because the near-term option is going to be more dramatically affected than is the longer-term one.

Now, you know how the options are priced, but no one knows for sure if these assumptions are good or not. For example, late last year, Corgentech (CGTK) announced drug trial results (that had been expected “sometime late in the year”). The results showed that the drug fared no better than a placebo -- in other words, it did nothing. This was very bad news and the stock fell 11 points from 19 to 8, roughly.

Where was the December 20 straddle price on the day before the event? At 3.50! Grossly underpriced! This proves there is no science to this. You need to look for situations where you have an opinion that is not properly reflected in the option's price.

Usually, the straddles are too cheap although it’s painful when you buy one and the stock goes nowhere after the announcement. In our previous theoretical example, the near-term straddle would be selling for more than 9. Because our assumption was that the stock was going to rise to 56 or fall to 46, we certainly wouldn’t want to buy that straddle. If, in fact, the stock opened unchanged at 50 after the “event,” and the options dropped to an implied volatility of 60%, the straddle would collapse to approximately 5.70.

It is best to play the FDA news events (and legal events), rather than earnings. The strategy should be a near-term straddle buy or -- if one has a feeling about the distance the stock will move -- a calendar spread whose strike is near the price that one expects the stock to move to.

Again, using the above example, if we expect the stock to rise to 56 (from its current price of 50), we’d buy a calendar spread with a striking price of 55 -- the closest strike to our estimated target price of 56. Sometimes, if you regard the situation as a fifty-fifty event, you could buy a call calendar spread with a striking price above the current stock price and also buy a put spread with a striking price below the current stock price.

Step-by-Step Recap
Looking for situations where the near-term options are more expensive than the longer-term ones is the first step in identifying “events” that the option market deems volatile. Next, do some research to see if you can determine what the outcome of the event is likely to be. Finally, buy straddles if you expect the event to be more volatile than the option market is expecting (this is often the case) or establish calendar spreads with striking prices at levels where you expect the stock to move to.