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Earnings Straddles, Implied Volatility, and Post-Earnings Drift

Article Quant Q&A · Author: CQM
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Summary

The document considers whether the cost of a pre-earnings straddle predicts the size or direction of the stock’s move after results are released, and whether options hedging explains that behavior. The response points to post-earnings-announcement drift: prices often react sharply at first and then continue moving in the same direction over subsequent weeks. It also notes research comparing stocks with and without listed options, reporting that optioned stocks tend to incorporate prices more quickly.

The discussion does not establish that options prices cause or reliably predict the subsequent move. Earnings surprises, informed trading, changing risk appetite, and noise are all offered as possible influences. Implied volatility skew and its behavior around announcements are also raised, without a clear pattern being asserted. The answer references prior studies but gives no study designs, estimates, or trading test, so it is best read as a guide to relevant mechanisms and research questions rather than evidence for a straddle strategy.

Key ideas

  • Post-earnings-announcement drift describes continued movement after the initial earnings reaction.
  • The response says stocks with listed options tend to reach the correct price faster than stocks without them.
  • A straddle’s implied move does not by itself reveal the direction of the earnings reaction.
  • Informed trading, risk appetite, and noise are possible explanations, but the document does not distinguish among them.
  • The referenced research is not summarized with enough detail to establish a predictive trading rule.

Tags

OptionsEquitiesEvent-drivenVolatilityStatistics
Full text
# Science behind options pricing into Earnings event


# Science behind options pricing into Earnings event












I am wondering about studies regarding the uncanny options pricing into public company's earnings reports.

The phenomenon being that the price of a straddle before earnings costs near exactly the positive or negative move that the stock makes after the earnings is released to be unprofitable or breakeven

It is curious because for example, the stock will frequently move 5% in either direction after earnings, but nobody knows which direction, the options aren't priced for a 2% move down and a 5% move up, they are priced for a 5% move up or down. You can look at the price of the straddles before earnings to determine how much the stock may move in either direction.

Is the stock price after the earnings release related to a hedging strategy that large market participants must do? Has anyone done any real study on this and compared to issues that don't have active options contracts? I've "heard" that it is a reaction to things said in the earnings call and I've heard a lot of things, but this doesn't explain the predictive nature of the options

## Answer by John (score 4)

https://quant.stackexchange.com/a/3873

You discuss the behavior of stock prices after an earnings announcement. There is a significant amount of academic research on this topic (called post-earnings-announcement drift). It basically finds that stock prices tend to move sharply initially, but continue to gradually follow in the same direction as the initial move for several weeks thereafter. I'm not sure if this behavior can necessarily be connected to options markets. For instance, there is research into the size of the PEAD when firms have options on their stock and when they don't. The stocks that have options tend to move to the "correct" price faster than the ones without options.

As for the direction of the stock price move, markets typically look to whether the firm beats estimates or not. If the firm beats estimates, then the stock price rises, and vice-versa. Hence, it is not unrealistic to expect stocks to either go up or down sharply following earnings.

When you say that options aren't priced for a 2% move down and a 5% move up, that's like saying the implied volatility curve is not as skewed before earnings announcements. Normally, implied volatility will have a skew/smile as a result of out of the money put contracts being expensive (people are buying protection to hedge themselves against a decline in prices). This presentation: http://users.iems.northwestern.edu/~armbruster/2007msande444/presentation4.pdf suggests that there is no clear pattern of the behavior of implied volatility before and after earnings announcements. If there were movement, it could be informed trading in anticipation of a better/worse earnings release and call, or it could be due to a broader change in market risk appetites, or it could just be noise trading.

Nevertheless, there's a lot of research related to options pricing around earnings, such as:

http://www.uic.edu/cba/accounting/Documents/VanBuskirk-paper.pdf

http://onlinelibrary.wiley.com/doi/10.1111/j.1911-3846.1997.tb00531.x/abstract

http://andromeda.rutgers.edu/~vdimitr/DIFOPN.pdf

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1858881

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1512046

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1508174

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