Implied Volatility Skews During Earnings

Posted on Thursday, January 23, 2020 at 2:35 PM

If you don’t trade options over earnings announcements, you may not have noticed what happens to implied volatility (IV) levels. Usually an expected volatility event like earnings increases the price of options. In other words, when implied volatility increases, so do option prices. That can give an option trader an edge, but that edge is based on a volatility event. Let’s take a quick look at a recent example.

International Business Machines Corp. (IBM) closed at $139.17 before its earnings announcement, which came after the close as seen below.

What if an option trader thought the stock might move higher after the announcement? There is some potential resistance around the $145 level, so he decides that looks like a good potential target. He can buy a long call calendar using the 145 strikes. He could sell this week’s expiration and buy the following. Take a look at the option chain below before the announcement.

Notice how much higher the IV is for the short 145 call (Jan-24) that expires the closest after the announcement. The long 145 call’s (Jan-31) IV is still elevated but much less than the short option. This is the IV skew that gives the option trader an edge because he is selling more expensive premium (62.49%) than what he is buying (37.22%). The unknown factor is what the stock will do after the announcement and up until Jan-24 expiration. There is an edge but also a big unknown.

After the announcement, both IVs are reduced with the short option (Jan-24) IV falling a lot more percentage-wise than the Jan-31 expiration. Take a look below.

Vega changes the premium for every 1% change in IV. In this case, it lowers the premium because of the IV drop. As you can see, the stock moved higher much to the delight of the option trader. The sold option has lost more than the long option, which can lead to a profit as well as some positive delta in this case.

There is a distinct IV advantage when it comes to IV skews over earnings. But there’s also uncertainty as to where will the stock go after the announcement. As always, everything in option trading is a trade-off.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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