Chapter 4: Trading around earnings announcements (Earnings)
Earnings announcements are among the biggest price movers, and around them implied volatility (IV) follows a repeating pattern: it rises before the announcement and drops right after.
| Two weeks before earnings | Implied volatility starts to rise gradually |
| Announcement day | Implied volatility at its peak: contracts at their most expensive |
| After the announcement (next day) | Implied volatility suddenly drops (IV Crush) |
| The effect of the volatility drop | Options bought before the announcement lose value even when the stock moves |
Expected Move
The market tells you how far it expects the stock to move after the announcement. A rough measure is the price of the at-the-money straddle for the first expiration after the announcement. Example: a stock at $200, with the call and put at the $200 strike together costing $12. The market is pricing a move of about $12 up or down, or about 6%.
An example of a volatility drop
In the example you bought the straddle for $12, the announcement came out, and the stock moved only $8. After the announcement implied volatility falls, so the two contracts are worth little beyond the move itself: about $8 plus a small amount of remaining time value. You lose roughly $3 to $4 per share even though the stock moved, because the move was smaller than what you paid for.
Three approaches and what each one bets on
- Buying a Straddle or Strangle: a bet on a bigger move than the market has priced in, in either direction.
- Selling or the Iron Condor: a bet on a move smaller than the one priced in. Selling both contracts uncovered (Short Straddle) can lose a great deal if the stock surprises the market. The condor caps the loss with a ceiling.
- Calendar spread: a bet that near-term implied volatility will fall more than far-term volatility after the announcement.
Common mistakes
- Buying contracts before the announcement without comparing the expected move with what the profit needs.
- Forgetting the announcement date: many companies announce after the close, so the effect lands at the next session's open.
- Relying on a past announcement: the stock's move last quarter doesn't mean it will repeat.
Summary
Contracts are expensive before earnings because the market is pricing the expected move, and after the announcement volatility falls and they lose that value. So profit doesn't come from guessing direction alone. It comes from comparing the move you expect with the move that's priced in: larger than priced means buying volatility, smaller means selling it with a limited loss.
