Earnings season is a good reminder that stock performance is ultimately linked to the fundamentals of a company's current and ongoing business prospects.

While different industries are assigned varying degrees of leniency in producing profits for shareholders, investors usually want to see progress in the form of rising revenues and/or falling costs. Outstanding business prospects can lead to big pops in underlying stock prices, and vice versa.

While the actual earnings a company reports for the quarter are certainly important, forecasts provided during earnings conference calls also play a big part in whether a stock moves up or down on the day the report is released.

Essentially, earnings provide a glimpse into the current operations of a company, and theoretically remove a degree of uncertainty from a company's fundamentals. Unless a company reports that things aren't going so well, and may get worse - which could actually make ongoing uncertainty go up.

Implied Volatility Crush

The mysterious shroud that blankets a company's earnings day is a big reason that implied volatility in options tends to pick up prior to the announcement (particularly in the expiration month that captures the earnings date) and decreases significantly immediately after the announcement - this is referred to as implied volatility crush.

As you probably already know, an option's value can be broken down into two components - intrinsic and extrinsic. It's the latter part, the extrinsic value, that represents the "risk premium" in an option.

If perceived uncertainty in a stock's price is increasing, demand for option contracts in that security rises. When this happens, the extrinsic value of the options increases in value, which can be observed through rising implied volatility. This is generally what is observed as a company’s earnings date approaches.

implied volatility crush

Monitoring various straddle prices in earnings expiration months across a wide range of stocks is a good way of learning more about how the market tends to price earnings events.

Earnings Example

For example if stock XYZ is trading at a price of $100 the day before earnings, and the straddle with one day to expiration can be bought or sold for $2.00 the day before earnings, that means the market is expecting a 2% move on earnings day ($2.00/$100 = 2%). On the other hand, if the same stock XYZ had a straddle price of $20 the day before earnings, that would mean the market was expecting a 20% move on earnings ($20/$100 = 20%).

Even new traders can quickly recognize the vast gulf between the market’s expectations for earnings in these two hypothetical scenarios. If a trader saw opportunity in the 20% scenario and sold the straddle before earnings, the position would theoretically be a winner if the stock moved less than 20% on the day of earnings.

Alternatively, under the 2% scenario, if a trader looked back at the previous earnings announcements and sees that stock XYZ has tended to move (on average) roughly 2% on earnings, he/she may elect to do nothing because they believe the current straddle is “fairly” valued.

Whether the earnings release itself is good or bad, new information is now available to the market that allows investors/traders to re-value the stock. And unless a company has announced the possibility of a binary event occurring at some point in the future (i.e. they are putting themselves up for sale), uncertainty, for the time being, has theoretically decreased.

This is when the magic of the earnings trade truly materializes. Decreasing uncertainty typically equates to a lowering of implied volatility.

It's important to note that even when stocks make big down moves after earnings, underlying options still experience volatility crush. This may seem counterintuitive because equities tend to be inversely correlated to fear. For example, when the S&P 500 goes down, one generally expects to see the VIX go up.

However, in the case of earnings, even a bad report provides valuable insight into a company's operations. The information provided allows a stock to be re-priced, no matter the direction. Either way, uncertainty is reduced, and implied volatility still typically drops - especially in the expiration month containing earnings.

It is possible that a poor report could cause implied volatility in the expiration month of the next scheduled earnings to get bid up (when it is listed), though this is by no means guaranteed because a lot can happen in the interim.

As you can see from the above, earnings volatility is dynamic and offers a variety of opportunities to vigilant traders. If you want to learn more about volatility crush, the tastytrade website has an extensive library of relevant material - not to mention new content available daily through tastytrade live.

As always, it’s important to ensure the risks of any potential position fit your risk profile and outlook. We encourage you contact us at support@tastytrade.com if you have any questions or want to learn more about trading corporate earnings.

The following links may also be of interest:

Options Jive: Earnings Volatility Explained

Market Measures: Selling Premium Around Earnings

Options Jive: Setting up Trades for Earnings

Happy Trading!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.