I know a *little* bit about volatility, but not enough to understand what happened to this DNA straddle. On Thursday, before we knew whether GenenTech (DNA) would get their new drug approved, the $75 March Straddle sold for $5.83 with 32.29% implied volatility. On Monday morning, once the market knew that the drug was Approved, the stock shot up 10% from $72 to $79. But - the March $75 straddle dropped in value to $4.95, with new IV of 21.36%. So what is going on here? Is the drop in Straddle value because IV is lower? So, we're saying that the market expected a greater move than 10%? That's the only thing I can think of to explain the drop in Straddle price, but the original IV of 32% didn't suggest the market was expecting lots of volatility that didn't materialize. Any thoughts from someone who understands straddles / options better than I do?
1) The drop in the March/75/straddle is due to volatility decline. There was probably a huge build up of speculative option buying that drove up implied volatility levels before the announcement and aggressive liquidation of those positions upon confirmation of the news which led to lower implied volatilty levels. 2) It may be better to focus on the March/70-75/strangle as a reference because the stock was at ~$72/share before the news. That position appears to be nearly unchanged after the price move in the stock. It is said that the strangle had "contained" the market by the amount of premium in the position, a useful piece of knowledge before the news came out! 3) In my view, the options market discounted the news almost exactly, i.e. a 10% move up or down. The premium/volatility levels became a self-fulfilling prophecy. Sometimes, it works out that way.
Based on 32.29%, the market expected about 9% move, which is about the same as the actual move, add in the slippage and you have a loss. Also the straddle was bearish since the call was OTM.
Straddles are symmetric about the strike. Thus, if nothing else had changed, the 75 straddle would be worth the same whether the stock was at 72 (3 points below strike) or 78 (3 points above strike). When the stock went from 72 to 79, your straddle experienced effectively a one-point move away from the strike (78 to 79), and a pretty significant IV collapse.
i've found that usually if a stock moves up around 10% on news, IV drops. if it moves down 10%, IV pops. plus it moved against you (smaller effect), and 2 days of decay (smallest effect)
Actually in cases like this (FDA decisions and etc) the IV collapses no matter which way the stock moves.
The stock moved in favour of the straddle by 1 point. The straddle was worth 3 intrinsic before, 4 intrinsic after.
Hey, thanks for the responses, I've learned a lot from this thread. I like knowing that the $75 straddle should be priced the same with a $72 underlying price, and a $78 underlying, since they are both 3 dollars away from the strike (all else being equal). MTE - you said "Based on 32.29%, the market expected about 9% move" Can anyone explain how this calculation is derived? That would be a very useful piece of information.
0.3229*sqrt(29/365). Volatility is scaled by the square root of time. So annualized volatility (32.29%) times the square root of days to expiry (Mar contract had 29 days to expiry on Thu last week) divided by 365 days in a year.