The market continues to be very volatile. It seems anything a Federal Reserve member comments on moves the market. Inflation numbers have caused big moves as well. Implied volatility levels have risen from the previously low levels of a few weeks ago. With a new round of quarterly earnings about to kick off, let’s consider how these announcements might affect IV levels.
What Is Implied Volatility?
The definition of implied volatility I like best is that it is the estimated volatility of the underlying in the future that is reflected in the price of the option. Historical volatility is the volatility of the underlying based on the past. It is basically how quiet or volatile the stock has performed in the past, which is usually reflected on the underlying’s chart.
IV Levels Rise Around Volatility Events
Keeping this simple, IV will continue to rise for expirations that take place after the earnings announcement as the earnings date get closer. This is particularly true for volatile stocks that have gapped in the past after the announcement. In other words, option prices will increase due to IV levels rising all other factors being held constant knowing there is a significant chance there will be a reaction to the announcement.
For an option trader, it is good to be positive vega (measure of the option’s sensitivity to changes in IV) with an expiration that takes place after the earnings date before the announcement and negative vega after the announcement. IV levels will usually always fall after the announcement even if the stock gaps a fair amount.
IV Does Not Rise for All Expirations
Many option traders will use the 30-day IV and HV. When the earnings date falls within 30 days, the 30-day IV will rise. The IV level will then be above the HV level, which many option traders look for when assessing if IV is high or low. Here is something I love to tell option traders about that. Just because the 30-day IV is above HV does not mean the expirations that take place before the announcement are elevated too.
Take a look at the two screenshots below. The company is expected to announce on April 19th (within 30 days). The first screenshot shows the 30-day IV above the 30-day HV.
The second screenshot shows the IV level much lower for the expiration that takes place prior to the announcement and the expiration right after the announcement. The bottom line is, not all IV are elevated as the first graph shows.
The Announcement
As mentioned above, IV levels will decrease after the volatility event is over. It may be tempting to hold long positions over the announcement, but it can also result in bigger than expected losses. Just know that option prices will decrease because of the IV dropping afterward. That is why holding a positive vega position over the announcement may not always be prudent.
Many option traders find that out the hard way in that they are not well educated about the IV crush. On paper it may seem attractive knowing there is a good chance the stock will gap. The reality is the drop in IV with the subsequent drop in the premium from vega may spoil profitable chances if there is not a big enough move in the underlying.
Proceed With Caution
There are plenty of things to think about as an option trader let alone when quarterly earnings are taking place. Should I trade over earnings, and if I own shares should I consider a collar to protect those shares? But knowing the basics of how implied volatility may affect your option position before and after the announcement can really be a game changer. Good luck!
