Options Theory: Earnings and the Volatility Cycle
August 31, 2017
Last Update: August 2021
Like any freely traded asset, the price of an options contract is driven in large part by supply and demand. When options are in BIG demand, their premiums rise. Traders aggressively buy up options for protection (specifically put options) when stock prices are plunging. Or, they may buy up options in anticipation of a big event like an FDA announcement or earnings announcement that has the potential to move a stock dramatically.
Conversely, when everyone is selling options contracts, their premiums fall. Really, there’s two ways to think about this. Either everyone is selling options (excess supply) or no one is buying them (lack of demand). Both dynamics will put downward pressure on premiums.
The price of an option matters because it tells us whether it’s a particularly attractive time to be a buyer or seller of them. When options are cheap they’re less attractive to sell (or, more attractive to buy). And when options are expensive, they’re more attractive to sell (or, less attractive to buy). Got it?
So how do we know if they’re cheap or expensive. Said another way, how do we know if the masses are buying up options or selling them?
Implied Volatility
The answer lies with implied volatility.
Implied volatility (or, implied vol for short) is the metric that reveals just how in demand options are. Here’s how to think of it:
- Demand UP > Premium UP > Implied Vol UP
- Demand DOWN > Premium DOWN > Implied Vol DOWN
You can measure the implied volatility for options on the S&P 500 using the CBOE Volatility Index (VIX). This is the most popular gauge of implied vol and is used to assess whether options are cheap or expensive on a broad level. Just like traders use the S&P 500 to quickly judge whether the overall stock market is bullish or bearish, you can use the VIX Index to quickly determine if options are generally cheap or expensive.
Here’s how the VIX looks over the past year. Since demand for protection rises during market selloffs, virtually every single spike in the VIX is caused by a sharp drop in the S&P 500. For this reason, we say the VIX has an inverse relationship with the stock market.
Now, while the CBOE Volatility Index allows traders to assess option premiums on a broad level, each individual stock that offers listed options has its own measure of implied volatility. You can track the demand for options on AAPL, GOOGL, MSFT, TSLA, or hundreds of other securities.
Like the VIX, the implied vol for individual stocks often rises when those stocks fall. And that should make sense. When Apple Inc. shares are crumbling, you can bet traders are running out and bidding up put option premiums for protection. Alternatively, when Apple Inc. is in a strong uptrend near all-time highs, fear is low and there isn’t as much motivation to buy insurance in the options market.
But there’s another unique dynamic with the way implied vol for individual stocks works. And it has to do with earnings announcements. These are quarterly rituals where public companies open their books and allow shareholders to see how business has been. They divulge their revenue, expenses, debt, earnings, and so forth. This is where the rubber meets the road, where perceptions meet reality.
Companies that smash expectations are often rewarded with overnight double-digit gains. And those who dare to disappoint can be punished with massive losses. This is why you’ll see large gaps in a stock’s chart every three months. Now, think about how this crazy quarterly volatility will impact demand for options. Do you think traders are willing to pay more for protection ahead of these events?
Of course, they are!
And what of the aftermath? What about after the earnings release and reaction? Once the cat is out of the bag the stock typically reverts back to its typical behavior. It’s not like it’s going to keep gapping every day. And so after earnings, demand for options drops back.
This pre-earnings ramp in demand and post-earnings demand dump creates a quarterly rise and fall in implied volatility. That means options get progressively more expensive into earnings and then immediately cheaper thereafter. The immediacy of the post-earnings volatility drop is why many refer to the phenomenon as a “volatility crush.”
I’ve included an example of Tesla below.
Earnings Trades
The consistency in implied vol’s behavior surrounding earnings makes it an interesting variable to game. For example, many traders like to “sell vol” into earnings to capitalize on the volatility crush. This is why Short Strangles and Iron Condors are often initiated just before the announcement. The pumped-up option premiums allow you to sell far out-of-the-money options to create a wide range of profit. Plus, the vol crush helps speed up your profit accumulation since premiums shrink rapidly the day after earnings.
This venture is not without risk, however. If the stock gaps too much after the event you can lose more on the adverse movement than you made due to the falling implied volatility.
And since implied vol typically troughs a few weeks or a month after earnings, this is often an attractive time to consider long volatility trades like a long call or put trade (or spread) if you have a directional opinion.
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Very interesting!
Great article!