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) to Amazon (AMZN) 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). 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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