In a pattern that Google Inc. (NASDAQ:GOOG) options traders have become accustomed to, the company reports earnings this week a day before options expiration. And there are two essential ways that options traders gauge the risk and the potential impact of that event on the stock as they buy and sell options before it. The first is the at-the-money (ATM) straddle and the second is implied volatility. The ATM straddle is simply the combined prices of both call and put at the strike which is closest to the underlying price. As of 12 p.m. EST today, the July 490 straddle was trading for a total premium of around $23.40. In its simplest form, this means that option traders are willing to sell you both the put and the call on a risk-weighted bet that GOOG moves will be contained within a range of $23 higher or lower between now and expiration. Since the July options only have one trading day of life left after GOOG reports, the straddle is very telling about what the market as a whole expects from the company. A $23 move from $590 equates to about 4.7%. Since this is actually a tad less than typical post-earnings stock moves for GOOG, it seems the markets are pricing in a tame reaction to a potentially in-line report. Part of the this mild anticipation might also revolve around the fact that the stock has fallen much more than the broad market recently, hitting lows this month nearly 30% off its 52-week highs. The $50 move higher in the last five trading sessions could be a mere retracement in its technical bear market since the 50 and 200-day moving averages crossed negative in May. But it is also driven by bullish expectations about the “king of the web” reaffirming its earnings power with another chunky dose of profits per share, with the consensus estimate coming in at $6.54 EPS according to Thomson Reuters. And a $500 stock price divided by potential full-year EPS of $26 produces a sub-20 P/E multiple, a very attractive valuation for such a dominant high-tech company.

What does the bell curve say?

The second way that options traders gauge the risk of stock positions before an earnings event is through implied volatility. The bell curve diagram below marks the expected trading range that option traders are betting will be most likely after GOOG’s report. Since option volatility is just standard deviation, the 58% volatility implied by options prices is telling us that there is about a 68% chance GOOG will remain within a range of $30 higher or lower (from current levels around $485 at noon on Tuesday) through July 16 options expiration.

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To understand where this data came from, see the snapshot of the Probability Calculator below. The “$30 up or down” that I highlight on the bell curve above comes from the options implied volatility on the Probability Calculator. Option markets are putting an expectation of 58% volatility into the July options that suggests the stock will likely move up to but not more than 6.2% (higher or lower) in the four days to expiration. Since the 58% is an annualized number, the Probability Calculator breaks it down into a standard deviation of 6.2% for the next four days - and 6.2% of $485 is $30.

Click on image to enlarge!

Why does implied volatility suggest a bigger move is expected? Since volatility measures are just functions of basic statistics, the annualized volatility number always represents one standard deviation. So in this case, since we have converted it to a volatility number for the next four days, we are seeing that there is about a 68% chance of GOOG staying within a range of 6.2% higher or lower. Should we be concerned that implied volatility is suggesting a bigger earnings reaction move than both the straddle and than the typical GOOG move of about 5%? This is simply the nature of implied volatility (IV) when you get this close to expiration. A few weeks ago, July ATM IV was closer to 40%. What happens as the number of days dwindle is that option prices have a much greater impact on IV, inflating it by as much as 10-20% depending on the pricing model’s method of calculation. But, this doesn’t mean that IV is worthless the week of expiration. In fact, it can be very useful when combined with the straddle because it gives you a “top-end” of the range for expected moves. If you experiment with the Probability Calculator for your stock and option trades, inputting option expirations and price levels you want to see the likelihood of reaching by those dates, you will start to see how volatility impacts option prices and vice versa and you will gain a new knowledge edge in all your trades.

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