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Monday, April 25th 2022

Earnings Crush Implied Volatility

The fall of implied volatility after earnings is the earnings crush.

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Summary

Earnings crush is the fall in implied volatility after earnings is announced, with front month expirations generally having higher IVs than back months. Measuring the effect involves estimating where IV will fall in each expiration, with a rational term structure where expirations fit into a smooth curve drawn over time. An options trade to take advantage of high IV vs ex-earnings IV is a time spread or calendar.

Earnings crush is the fall in implied volatility after earnings is announced. Typically, earnings announcements cause the price of the stock to move more than normal. The move will have more effect on short dated expirations since the day of earnings large move has more weight than the rest of the days with normal moves.  For this reason, front month expirations will generally have higher IVs than back months. After earnings, the implied volatility falls more in the front months than in the back months for this reason.  

There are various measurements to view this effect. Measuring the effect starts with estimating where IV will fall in each of the expirations. This can be accomplished by estimating an earnings effect in each month and varying the effect until the relationship between the IVs make a rational term structure. A rational term structure is where the expirations fit into a smooth curve drawn over time. The term structure is not necessarily a flat as many calculations use. Sometimes the term structure will solve to contango, with a a lower front month, or in backwardation with higher front IVs than back month IVs. 

When the part of IV that is the earnings effect is extracted from the raw IV, an ex-earnings IV can be compared. Below is a list of stocks with IV 30 day divided by ex-earnings IV 30 day sorted from highest to lowest.

UPS is the highest ratio at 1.31 with the IV=49.48% and ex earnings IV=37.78%.

 

Here's a view of the monthly unadjusted ATM IV for UPS. May 27th is about 30 days out and the IV is 48%. Constructing a rational term structure taking out an earnings effect over the months makes a 38% ex earnings IV for May 27th. The front month of 4/29/22 trading at 106% IV is expected to come down to 47%. The term structure, post earnings is still in backwardwardation. 

 

An options trade to take advantage of this high IV vs ex earnings IV is a time spread or calendar. 

 

The May-20 June-17 $185 Long Call Calendar has the following profile:

 

The break even points are estimated at $168.38 -9% and $205 +11%.

The history of UPS moves versus expectations are below:

 

There are two moves of +14% in the last 12 observations but the rest of the earnings moves would probably result in a winning trade.

 

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The opinions and ideas presented herein are for informational and educational purposes only and should not be construed to represent trading or investment advice tailored to your investment objectives. You should not rely solely on any content herein and we strongly encourage you to discuss any trades or investments with your broker or investment adviser, prior to execution. None of the information contained herein constitutes a recommendation that any particular security, portfolio, transaction, or investment strategy is suitable for any specific person. Option trading and investing involves risk and is not suitable for all investors. For more information please see our disclaimer.
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