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Earnings, Dividends, and Implied Volatility in Short-Dated American Options

Article Quant Q&A · Author: Rocky the Owl
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Summary

The document poses an options interview scenario in which a stock has a large dividend followed by an earnings announcement during the life of a near-term at-the-money American call and put. It proposes thinking of implied variance as a time-weighted combination of baseline daily variance and event-related variance, with earnings assumed to contribute more uncertainty than the dividend. It then speculates that implied volatility could rise as the remaining period becomes more concentrated around those events and fall after the dividend date.

This is an attempted answer rather than a resolved analysis. It gives no option-pricing calculation or market evidence, and the proposed weighting is not enough to establish whether a quoted volatility is fair. The dividend can materially affect the stock price and early exercise incentives for American options, while earnings uncertainty depends on the announcement and its expected move. The document raises put-call pricing as a further question but does not explain a trade or arbitrage response, so its timeline intuition should be treated cautiously.

Key ideas

  • The scenario combines a dividend and an earnings announcement within the life of short-dated American options.
  • The proposed intuition models total implied variance as contributions from ordinary days and event days.
  • The author expects earnings to contribute more uncertainty than the dividend payment.
  • The document does not establish fair value or resolve how to respond to the put quote.
  • Dividend-related price changes and American early exercise complicate simple volatility-weighting intuition.

Tags

OptionsVolatilityDerivatives pricingEvent-driven
Full text
# Volatility basics: what happens to implied volatility of stock in week of earnings and dividend payment?


# Volatility basics: what happens to implied volatility of stock in week of earnings and dividend payment?












Question: Imagine it is a Monday. Company A (stock you are following) has an upcoming dividend payment on Wednesday and an earnings announcement on Thursday. Company A stock is currently trading at \$10; dividend will be \$5. The implied volatility of the call option (strike = 10, expiration = Friday end of day) is 30 vols. These are American options.

(a) Qualitatively explain what might happen to the implied volatility in the above scenario. How might you go about thinking whether the volatility level is fair? (b) If a put option (strike = 10, same expiration at call) was offered in the market at the same vol reference of 30 vols, what would you do (if anything)? Why?

Attempt:

(a) My only experience with equity options volatility calculations is by doing simple 'weighted-average' calculations. That is, for our 5 days, I would think about doing something like: $$ \sigma_{\text{implied}} ^2 = \frac{1}{5}\sigma_{\text{Monday}} ^2 + \frac{1}{5}\sigma_{\text{Tuesday}} ^2 + \frac{1}{5}\sigma_{\text{Wednesday}} ^2 + \frac{1}{5}\sigma_{\text{Thursday}} ^2 + \frac{1}{5}\sigma_{\text{Friday}} ^2$$

This was asked as a question to talk aloud through (so no access to calculators, computer, etc.) so then perhaps we make the assumption that the volatilities for Monday, Tuesday, and Friday are equal to some baseline daily volatility level $\sigma_B ^2 $. Then we can make the assumption that the volatility on the day of earnings $ \sigma_E ^2$ will be greater than the volatility on the day of the dividend payment $\sigma_D ^2$, so the equation becomes:

$$ \sigma_{\text{implied}} ^2 = \frac{3}{5}\sigma_{B} ^2 + \frac{1}{5}\sigma_{D} ^2 + \frac{1}{5}\sigma_{E} ^2 $$

Then, as we go throughout the week, there will be a greater weighting on the earnings day and the dividend payment day and thus the volatility will increase up until dividend payment, after which it will decrease for the Friday. For example, on Tuesday morning the above equation may look like:

$$ \sigma_{\text{implied}} ^2 = \frac{2}{4}\sigma_{B} ^2 + \frac{1}{4}\sigma_{D} ^2 + \frac{1}{4}\sigma_{E} ^2 $$

Then for part (b), I don't really know how to think about the question.

Thanks in advance!

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.