If you don’t trade options over earnings announcements, you may have not 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 below at a recent example.

General Electric Co. (GE) was trading at $110.56 the day before its earnings announcement, which came before the open the next day as seen below.

What if an option trader thought the stock would not move much after the earnings announcement and that it would continue to trade around the $110 level? He could buy a long call calendar using the 110 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 110 call (Jul-28) that expires the closest after the announcement. The long 110 call’s (Aug-04) 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 (50.44%) versus what he is buying (35.37%). The unknown factor is what the stock will do after the announcement and up until Jul-28 expiration (short expiration). There is an edge, but what the underlying does is obviously a big unknown.

After the Announcement

After the announcement, both IVs are reduced with the short option (Jul-28) IV falling as well as the long option (Aug-04) expiration. Below is a screenshot of the option chain taken about 2 minutes after the open the next day after earnings were posted.

Vega changes the premium for every 1% change in IV. In this case, it drops the premium because of the IV drop. As you can see, the stock moved higher than expected, which was not beneficial for this particular neutral calendar. Despite the move higher, the long calendar increased in value from 0.50 (3.15 – 2.65) before the announcement to 0.90 (6.70 – 5.80) the next day.

Finally

There is a distinct IV advantage when it comes to IV skews over earnings. Uncertainty comes along with it, however. In this case, the trader wondered where the stock would go after the announcement. As always, everything in option trading is a trade-off.

John Kmiecik, Market Taker Mentoring