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A stock’s movement can quiet down as it approaches its earnings announcement. Traders may be holding back making trades while they wait for the earnings information to be released. The earnings announcement date is known well ahead of time in most cases. Even if an exact date is not known, companies must report their earnings information quarterly (about every three months). It is well known that earnings can create a big movement for a stock. Floor traders, or market makers, (the people trading on the exchanges) know this as well. In the weeks approaching earnings the implied volatility typically increases in anticipation of this event.
What would seem “correct” is if the earnings information released is good, then a stock should go up. If the earnings information released is bad, a stock should go down. It’s just not that simple. A company can have stellar earnings and the stock could drop significantly when this news comes out, or vice versa; the stock increases significantly on bad earnings. There are other factors that come into play such as guidance, expectation, quarter-to-quarter comparison, year-over-year comparison, and the all-trumping event: public expectation and views. Regardless of any of the fundamental information, the general public’s view (in this case the trader’s) of the stock rules all. If the largest group of traders is bearish, down the stock goes. If the largest group of traders is bullish, up goes the stock. This is an oversimplification, yet the point still remains.
Let’s get back on point with the floor traders. If a stock typically moves significantly around earnings, the floor traders raise the implied volatility. The direction the stock will actually move may not be known, but a rough idea of how much it will move can be created or guessed. The implied volatility is up due to the “unknown factor” of the event. Once the earnings announcement is made, the “unknown factor” of the event is over and the implied volatility is taken out quickly.
For example, the chart below shows a stock that typically moves on its earnings announcement. On the bottom of the stock chart is the average implied volatility chart for that stock. The green arrows show implied volatility rising up just before the earnings event. The rise in implied volatility is making the options more expensive. The pictures on the chart of the blue book and the red phone are actual days of the earnings announcement. You can see via the red arrows that as soon as the earnings information is known the implied volatility drops significantly (called “volatility crush”). This stock is making some fairly large price moves from the earnings announcement, but often this plays second to what implied volatility can do to the profit and loss of a Straddle or Strangle.
To summarize what is happening, the Straddle and Strangle traders are buying “expensive” calls and puts going into earnings, and then selling them “cheap”. No trader can make money by buying expensive and selling cheap. In fact, despite some of the large moves from the stock itself, the Straddle and Strangle trades would have lost money. This typical correlation between earnings and high implied volatility is not necessarily a deal breaker for Straddles and Strangles, but it is something of which traders should be aware.
There is another aspect of which traders should be cautious: Floor traders are smart (at least when it comes to trading). There are times where it seems like they know exactly what is going to happen to a stock when it announces earnings. The floor traders will not let anyone have a “free ride” on a trade and have methods of preventing themselves from losing money. There is a relationship between stock prices and option prices which is known as “synthetics”. This relationship encompasses all aspects to the price and value of an option. There are times where the floor traders will price the move of earnings into the option chain, so that even if the stock has a HUGE move, the retail option traders cannot make any money. This can be seen through the pricing of Straddles and Strangles.
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