Earnings, Options and the Volatility Cycle

Implied volatility is the price of options insurance

   

Earnings season is viewed by some as a time rife with opportunity. Followers of fundamental analysis see it as a time of information acquisition, when companies open the books and divulge the details on the earnings, revenue, growth, and other revealing data on the health and performance of their company.

Adherents to charting see it as a season of gap plays. Given the preponderance of buying and selling occurring in response to the announcements after hours, the lion’s share of companies see their stock price gap up or down the day following the earnings release. Some gaps serve as catalysts fueling a major shift in the trend of the stock while others turn out to “one and done” events as the gap quickly fills.

Many stock traders find earnings season to be a disrupter to the normal ebb and flow of stock prices; an annoying event which often causes otherwise unpredictable multi-standard deviation moves. Savvy options trading investors see earnings in a different light — volatility light if you will.  Rather than disrupting the normal ebb and flow of volatility, earnings cause it.  Earnings announcements are the principle driver behind the cyclical ups and downs easily seen within a stock’s implied volatility chart. Consider this volatility chart:

Volatility1 e1302703863356 Earnings, Options and the Volatility Cycle

Volatility and Earnings Reports

(Source:  Livevol Pro)

The blue “E” icons mark earnings announcements over the past year. To better understand why implied volatility rises prior to the announcement while falling afterward consider the following two statements:

Options are Insurance

Implied Volatility is the Price of Insurance

Just as any insurance company adjusts the price of insurance based on the risks inherent to each individual client, the marketplace adjusts the price of each option based on the perceived risks of the underlying stock going forward. Though an actual insurance company thinks of risk as likelihood of injury or sickness, option traders think of risk as likelihood of a large move in the underlying. If the stock is perceived to have higher risk of a large move going forward, options become more expensive (implied volatility increases). That is, option buyers are willing to pay more while option sellers demand higher premiums to justly compensate them for the risk they’re taking on. If the stock is perceived to have less risk of a large move going forward, options become cheaper (implied volatility decreases). That is, option buyers are unwilling to pay higher prices while option sellers are willing to accept lower premiums.

Find more option analysis and trading ideas at Options Trading Strategies.

Options are continually seeking to price in or discount how much volatility a stock is likely to realize in the future. Since earnings announcements almost always cause an increase in realized volatility (think of the large gaps), options seek to accurately price in this up tick before it happens. Thus, there is almost always a rise in implied volatility in anticipation of the event.

What about after earnings?

Typically stocks revert back to their normal price behavior post earnings. With the catalyst in the rear view mirror options also revert back to pricing in a stock’s normal realized volatility. We usually see a sharp decrease in implied volatility to bring it more in line with reality, or at least the reality option traders expect to see going forward. Naturally this cyclical rise and fall in implied volatility should be taken into consideration by those trading strategies with a heightened sensitivity to volatility.

Since implied volatility has a tendency to bottom between earnings announcements that may be the ideal time to enter long volatility plays like calls, puts, straddles, or strangles.  On the other hand, since volatility tends to peak just prior to earnings most traders looking to game the earnings release attempt to structure short volatility plays to exploit the expected volatility crush.

One factor that sometimes upsets the volatility cart is a major macro movement in the equities market. This usually manifests itself as a broad based surge in volatility concurrent with a bear market or significant correction. The year 2008 serves as a prime example as implied volatility rose on virtually every stock regardless of when individual companies reported earnings each quarter. Since we saw earnings type moves on a daily basis, volatility remained stubbornly high throughout much of the year failing to exhibit the quarterly rise and fall.

Barring any type of bear market or significant correction the relationship between earnings and the volatility cycle is an easily identifiable phenomenon that plays out time and time again.

Follow Tyler Craig on Twitter@TylersTrading.


Article printed from InvestorPlace Media, http://investorplace.com/2011/04/earnings-options-and-the-volatility-cycle/.

©2014 InvestorPlace Media, LLC

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