Reviewing the market situation of NVIDIA's earnings report, how to make the right options trading?

Source: SanSi Options

Last week, it seemed like everyone was talking about Nvidia's earnings.

Before the announcement on Wednesday, all traders were quietly waiting for this announcement, discussing how much Nvidia would exceed expectations. When the earnings were finally announced, it was not disappointing, and it could even be said to be very impressive.

In after-hours trading, traders immediately pushed up Nvidia's stock by 10%, and the other 7 large tech stocks (MAG7) also rose significantly.

However, the excitement quickly faded the next morning at the opening bell - Nvidia opened at $502 (reaching a high of $516 in after-hours trading).

By the closing bell, Nvidia had even wiped out all its gains.

Looking back, this is clearly a classic case of "everything being fully priced by the market," where even exceeding expectations in earnings is not enough to drive the stock price higher. Unless your actions far exceed others, buying before the earnings report is released becomes a trade with a very poor risk-reward ratio.

Imagine if the earnings only met expectations or even slightly fell short, it could lead to a sharp drop in the stock price.

But there is something worse than this trade, which is buying call options before the earnings report is released. The purpose of this article is to analyze why you can't make money when trading options in the above-mentioned event.

Let's go back to Wednesday afternoon at 5 o'clock (US time), when Nvidia's stock price was soaring, and the options had already priced in about a 10% increase. The market's pricing was still quite accurate, as Nvidia did indeed rise by 10% in after-hours trading.

However, the next morning, Nvidia's opening price was close to $500, but still had a 6.5% increase. If you had bought call options before, as long as you sold them immediately at the opening bell, you could still make money. However, considering the stock's high opening and then a gap up of over $30 during the trading session, the profit from this trade is not significant.

For example, suppose you bought at-the-money call options for the next regular expiration date (September) - specifically, call options with a strike price of $475 expiring on September 15, 2023. The price at that time was $30, and it rose to $40 at the opening bell the next day.

But within half an hour of the opening bell, the price of the options fell below $30. Is it better to buy out-of-the-money options? The chart below shows the price trend of a call option with a strike price of $500 expiring in September 2023. The situation is exactly the same as that of an at-the-money option. The closing price the previous day was $20, and it rose to $26 the next day at the opening.

However, within half an hour, its price dropped to $15.

What if you buy options with a shorter expiration? For example, a call option with a strike price of $475 expiring on August 25, 2023. Its trading price before the earnings announcement was $20, and it rose to $27 the next day at the opening.

But two days later, they became worthless.

If we switch to out-of-the-money call options expiring on August 25 with a strike price of $500, the situation is even worse! Not only did the opening price hardly change, but within half an hour, the price dropped from $12 to $4.

What happened in the market? After the market opened, Nvidia's stock price continued to rise by $10, but the prices of the call options mentioned above were rapidly declining.

This is because after the event occurred, the market priced out the related risk premium, resulting in a sharp drop in implied volatility (VOL CRUSH)!

Let's take a look at the options from the perspective of implied volatility.

Before the earnings report was released, the at-the-money call option with a strike price of $475 expiring in September had a volatility of 67%. But after the earnings report was released, the volatility quickly dropped to 45%. This can be understood as a 22% implied volatility (67% - 45%) that the market priced in as a risk premium for the earnings report.

In other words, unless the actual volatility at the time of the event is higher than the implied volatility mentioned above, it is difficult to make money by buying call options. This means that even if you correctly predict the direction of the stock (upward), buying options directly will still result in losses.

Does this mean that Nvidia has no trading opportunities?

Shorting Nvidia's high volatility may be a consideration. But bearish options are not suitable for everyone. (Do you remember the sharp rise in NVDA's price after the last earnings report?) In addition, there are better ways to trade this market situation. The following chart shows the prices of call options with a strike price of $500 expiring in September, as well as the implied volatility.

At the beginning of the article, it was mentioned that many traders bought the company's stock in anticipation of better-than-expected earnings. Although the actual earnings turned out to be better than expected, the stock price did not rise as expected without new buyers entering the market, and the trend of implied volatility was the same.

For long-term stock investors, there is no need to sell the stock before the event occurs (although from a risk/reward perspective, it should be done). This is because NVDA still closed higher the next day.

However, for options traders, the correct strategy is to prepare in advance and hold volatility (only hold call options if you are bullish). When the earnings data is about to be released, sell to take profit.

Specifically, you can buy call options expiring in September with a strike price of $500 when the implied volatility is at 45%. Then, when the implied volatility rises to 70% on the day before the announcement, sell to take profit. Only then can it be considered a successful options trade.