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Wednesday, October 31, 2007

The Behavior of Implied Volatility (IV) & Historical Volatility (HV) Before & After Earnings Announcement

As mentioned before, Implied Volatility (IV) does factor in future important events / news which are expected to move the option’s price considerably within the next 30 trading days (e.g. earnings announcement, FDA approvals, etc.).

For some regular events, such as earnings announcement, which typically take place on a quarterly basis, we could see some common behavior before & after the announcement.
Generally, IV would normally start to increase since a few weeks before the announcement day.
Once the announcement is out, the IV will usually drop significantly.
On the other hand, the Historical Volatility (HV) may rise drastically should there were a significant gap up / down in stock price after the announcement.


RIMM’s Earnings Announcement: 28 Sep 06, 21 Dec 06, 11 Apr 07, 28 Jun 07, 4 Oct 07.

As we can see from the chart, the IV (Implied Volatility) was normally increasing when the announcement approached, and it dropped significantly right after the announcement.

On the contrary, when there was a significant price gap (up / down) after the announcement, the HV (Historical Volatility) increased drastically, reflecting the sudden actual price movement (e.g. Price gapped up after earnings announcement on 28 Jun 07).
Also notice that about 30 trading days after that, HV fell drastically. This is because the price data on the day just before the price gap occurred has been excluded from the HV calculation. (Remember that HV is a measure of the fluctuations of the stock price over the past 30 trading days).

Next, what’s the impact of the above behavior when we’re trading options over the announcement? We’ll discuss it further later. Please stay tune. :)

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

Related Posts:
* Trading Videos From Trading Experts You Should Not Miss
* Options Trading Basic – Part 2
* Option Greeks


Tony Chai said...

Hi OTB :

Nice article about the behavior of implied volatility for options of companies which are reporting earnings.

Like you've mentioned, implied volatility would normally increase as the company approaches earnings announcement, thus inflating the options premium accordingly.

It's for this reason that you must determine whether the position would yield a good risks/rewards ratio before embarking on it ie. the price gapping action would be more than enough to cover any significant collapse of implied volatility after the earnings announcement.

Yours Truly,

Tony Chai
My Options Trading Blog