Implied volatility (IV) levels have increased recently for the market as well as for many stocks. And even if stocks’ IV levels have not risen, that will change soon with the next round of earnings on the horizon. So how do earnings announcements affect IV? Let’s take a look.
What Is Implied Volatility?
The definition of implied volatility I like best is that it is the estimated volatility of the security in the future that is reflected in the price of the option. In essence, IV tells an option trader whether options are cheap or expensive. Historical volatility, meanwhile, is the volatility of the security based on the past. It is basically how quiet or volatile the stock has previously performed, which is shown on the underlying’s chart.
Earnings’ Impact
One major thing to keep in mind is that as an earnings date gets closer, IV will continue to rise for expirations that take place after the announcement. This is particularly true for volatile stocks that have previously gapped following an 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 beneficial to be positive vega (measure of the option’s sensitivity to changes in IV) before the announcement with an expiration that takes place after the earnings date and negative vega over the announcement.
IV Does Not Rise for All Expirations
Many option traders look at 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. But don’t be fooled. Just because the 30-day IV is above HV does not mean the expirations that take place before the announcement are elevated too.
Consider the two screenshots below. The company is expected to announce Jan. 9 (within 30 days). The first screenshot shows the 30-day IV (red) above the 30-day HV (light teal). The second shows the IV level much lower for the expiration that takes place prior to the Jan. 9 announcement and the expiration right after the announcement. You can see it is quite the skew from where it had been.
After the Announcement
IV levels will decrease after a volatility, such as an earnings announcement, is over. It may be tempting to hold long positions over the announcement, but know that option prices will decrease because of the IV dropping afterward. That is why holding a positive vega position (long option) over the announcement may not always be wise. Many option traders find that out the hard way if they are not well educated about the IV crush. I certainly did as a young retail option trader. On paper it may seem attractive knowing there is a good chance the stock will gap, but in reality the drop in IV causes the premium to drop and often makes it hard to realize a profit.
Final Thoughts
Trading options around quarterly earnings can be complicated, and for a newbie it can result in some big losses. When in doubt or without proper education, it may be prudent to avoid the announcements altogether. Better safe than sorry, as the saying goes!
John Kmiecik
Senior Options Instructor
Market Taker Mentoring
