Volatility and Earnings

• Posted by admin
• on November 11th, 2011

By: Joe Burgoyne, Director, Options Industry Council

The quarterly corporate earnings cycle and market volatility can provide investment opportunities for options traders. During these periods, investors may want to take a closer look at how volatility impacts both stock and option positions before and after earnings announcements.

There are two types of volatility: historical and implied.  Each measurement provides important information for the options trader.

Historical volatility is a measure of movement of an underlying security over a specific period of time. Investors may use historical volatility or past trading ranges as an indication of how much the stock price may fluctuate in the future. It must be emphasized that this is no guarantee that past volatilities will predict future price behavior. The range that a stock’s price has fluctuated in past periods is one of many important factors in determining which options to buy or sell, particularly around earnings periods.

Implied volatility is the market’s forecast for future movement of the underlying. It is reflected in the option premium – puts and calls – of an underlying product. Implied volatility reflects the investor’s positive or negative sentiment about future movements in a stock or index. Like any forecast, it may or may not hold true. Implied volatility is the key element in the time value portion of an option’s premium. When implied volatility goes up, call and put prices go up. When implied volatility goes down, options pricing goes down.

 

Earnings season is typically a volatile period. This volatility or expectation for greater movement often impacts the price of options. If you notice that overall implied volatility is higher for one option expiration over another expiration, then chances are that month may include an earnings announcement.

Let’s examine how changing implied volatilities can affect options prices. Just prior to earnings, the investor will notice that options tend to be on the pricey side. Let’s assume some investors have an outlook that a stock is going to move higher upon the release of earnings and decide to buy some call options. With the underlying stock trading $30, an investor purchases an at–the-money 30 strike call for $3. Directly after the earnings announcement, the stock moves higher by $2, but the option only increases in price by 50¢. What transpired was a reduction in implied volatility. The unknown is now known, and the uncertainty is taken out of the market, and as a result the lower implied volatility yields reduced time premium.

Vega

Any investor using options should also understand the concept of Vega. Vega is the change in an option’s theoretical value for every 1-point change in volatility. If the Vega on an option is a nickel and the volatility goes up a point, you can add a nickel to the price of the option without any change in the underlying stock. Understand that while theoretically Vega is the same for at-the-money calls and puts, in reality each option’s Vega is affected differently by volatility.

Furthermore, Vega varies depending on each option. There are options that have may have a nickel, 50¢, a $1, or even $2 worth of Vega. The largest Vega is going to be for an option at-the-money with the most time until expiration. So, longer dated at-the-money options have more Vega than short term at –the-money options.

A few things to consider prior to an earnings announcement:

There is no perfect trade and there is no perfect position. If your forecast is for volatility to increase, you might want to purchase options or buy a spread that takes a position of long volatility. A vertical spread is one example of a long delta option position with less volatility risk where the short out of the money call offsets some of the long Vega of the at the money call.

• When you’re buying options, you’re buying volatility and you’re buying Vega.
• If you’re selling options, you’re selling volatility or selling Vega.
• If you feel like volatility is going to decline upon the release of this earnings news, you may decide that you want to sell options, or sell a spread that gets you short volatility.
• Be aware that changing volatility levels can impact the other Greeks in your position, namely Delta and Theta. Also, be aware that the risks associated with naked short option positions are significant and sometimes unlimited.
• Implied volatility changes all the time.

In terms of volatility, there are a couple things that investors can look at going into earnings. A good place to start is to look at the relationship between historical volatility and implied just before earnings over the past 3 or 4 earning cycles. You can find some historical and implied volatility data on OIC’s website at http://www.optionseducation.org/quotes/default.jsp .  Examine the differences between the two volatilities before earnings as well as the relative levels of each.

To learn more about options, visit OIC’s website www.OptionsEducation.org. OIC has a vast collection of educational resources including webcasts, podcasts, multimedia online courses, and interactive tools such as OIC’s Strategy Screener and a Virtual Trading System.  If you haven’t already, register for a free account with OIC Education and get full access to these resources.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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