Options Trading

In every earnings season, we usually see several stocks that exceed their earnings estimates and experience a big jump in price, and several others that fall short of their estimates and sustain a big price drop.

Predicting which stocks will beat expectations and which ones will miss is tricky. In my experience, I’ve often seen an increase in implied volatility in many stocks as the earnings release date approaches, followed by a very sharp drop in implied volatility immediately following the release.

Implied Volatility Definition:

Implied volatility is usually defined as the theoretical volatility of the underlying stock that is being implied by the quoted prices of that stock’s options. In other words, it’s the estimated future volatility of a security’s price.

How Does Implied Volatility Change With Earnings?

• Implied Volatility if Low about 1 week prior to earnings
• Implied volatility increases as earnings approaches
• Implied volatility is highest the day before earnings
• Implied volatility decreases immediately after earnings announcement

How Does Options Premiums Change with Volatility?

• Long and Short option premiums increase with volatility
• Longs and short option premiums decrease with volatility
• Both are affected equally

Because implied volatility is a non-directional calculation, any strategy that involves long options will typically gain value as volatility increases (before the earnings report)—meaning that puts and calls tend to be affected about equally. For the same reason, long option strategies will typically lose value quickly as volatility decreases (after the earnings report).

As a result, buying calls (or puts) outright to take advantage of an earnings report that you believe will beat (or miss) the earnings estimates is an extremely difficult strategy to execute. 

This is because the drop in option value due to the decrease in volatility may wipe out most, if not all, of the increasing value related to any price change in the stock. In other words, a substantial price move in the right direction may be needed to end up with only a very small net gain overall.

Implied volatility is usually defined as the theoretical volatility of the underlying stock that is being implied by the quoted prices of that stock’s options. In other words, it’s the estimated future volatility of a security’s price.

While implied volatility spikes before earnings announcements will generally cause calls and puts to increase in value, those increases could be partially or completely offset by large price moves in the underlying stock.

Similarly, while implied volatility declines after earnings announcements will generally cause calls and puts to decrease sharply in value, those decreases could be partially or completely offset by large price moves in the underlying stock.

Strategies that may benefit from an increase in implied volatility include: 

• ITM vertical credit spreads, 
• short butterflies, 
• short condors, 
• ratio call back spreads and 
• ratio put back spreads.

Strategies that may benefit from a decrease in implied volatility include: 

• ITM (in-the-money) vertical debit spreads, 
• long butterflies, 
• long condors, 
• ratio call spreads and 
• ratio put spreads.