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Beware the Limits of Implied Volatility

For example, drug firm Adolor (ADLR) saw the implied volatility on its August front-month options surge from 50% to more than 115% in the five days prior to the Food and Drug Administration's scheduled July 25 hearing regarding the company's drug Entereg. This translates into expectations for a 20%, or $2, price change, either up or down, within a four-week period.

One quick way to gauge the expected move is to use a thumbnail calculation based on the price of the at-the-money straddle. With Adolor trading at $10 per share, the August $10 straddle (the total cost to purchase the $10 put and $10 call) was priced around $2. After the FDA released a letter providing for "initial approval" of Entereg, the immediate reaction saw shares jumping to an intraday high of $12.20. Sounds like a 20% move.

But as traders delved further into the full release, which included a statement that additional proof of the drug's effectiveness would be required before the company would be allowed to market the drug, the stock reversed course and ended up back at $10 per share.

This is a fine example of options accurately pricing in an imminent move, but it also highlights the nondirectional nature of implied volatility and the difficulty of realizing a profit even if what has been predicted comes to pass.

Options markets have been equally prescient in anticipating earnings causing a price movement with everything from Caterpillar (CAT - Get Report) to Amazon (AMZN - Get Report) seeing the implied volatility on their options ratchet up ahead of earnings to a level that fairly accurately predicted the resulting move.

Looking ahead, keep an eye on Pozen (POZN - Get Report). The drug company reported earnings on Thursday, basically met all expectations and saw its shares remain unchanged near $8.50 per share. Typically, following such an earnings report, the related options would undergo a contraction in pricing as the implied volatility level declined.

But the implied volatility in Pozen's options actually crept higher, to a very rich 108% level.

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