What’s it mean when you come across a trader or analyst chatting up their view on what to expect from a company’s earnings release? It could mean a whole lot of nothing of course, but if the dialogue is related to the company’s option prices, straddle or strangle markets in front of the report, it may be worth paying attention too.

On January 17 we began our investigation of this question and covered two methods of interpreting this pricing phenomenon in “Earnings Expectations Part I.” Discussed first was the most often used strategy by novice’s and pros alike, the at-the-money straddle market with focus on the non-directional spread’s breakeven analysis at expiration when the earnings event has very little time left until expiration.

We went on to address earnings expectations with a slightly more learned eye by taking the sum of the at-the-money straddle and surrounding-money strangle, then dividing by two to yield a slightly more robust estimate of trader expectations. Our second installment, focused on implied volatility and applying a formula based on the bell curve and standard deviation analysis to gauge a stock’s estimated move.

In today’s third and final installment on earnings expectations we’re going to examine straddle pricing and volatility crush as it relates to pricing a pending event such as earnings. In focus, we’re going to scrutinize this slightly looser method for short-term traders looking to make a play on implied volatility tied to the event with the intention of exiting or adjusting immediately after the report and initial reaction, as to keep the position’s objective as pure as possible.  

No disrespect to technical analysis, which we apply regularly and have an appreciation for, but when it comes to an expected move in front of a key event such as earnings, it’s much easier to have a fairly accurate view on where implied volatility will be after the news is out, than how traders will ultimately react in the underlying stock when all is said and done.

In the end, implied volatility maintains a fairly strong mean-reverting tendency to recent range values, as well as being tethered to the underlying statistical volatility of shares. On the other hand, what happens to existing robust trendlines, “Key!!” moving average or price support and resistance, bullish patterns like cup-with-handles or to bearish-looking flags or even our pal Elliott Wave after a report; well, that’s anybody’s less-critical guess.

In spite of what’s been said, traders can and should look to past earnings reactions for clues of history repeating itself in the underlying instrument. However, there may not be any strong discernible patterns. To boot, investor sentiment and how it manifests itself into a reaction in shares, in our opinion, is much more whimsical than what you’ll find with reading option premiums and where they’ll likely land versus a stock's technical tea leaves.

This all said, the anticipated or expected overnight shift in option premiums, particularly if there’s some time on the calendar until the earnings front month straddle expires, gives the trader a strong read on where one would not only breakeven as part of a strict, short-term earnings play position, but also how much would be gained or lost in the event the umm event, turns out to be a non-technical event which fails to make that day’s Percent Leaders board. 

Figure 1: Akamai (AKAM) Implied Volatility

To illustrate this process, we’ll be looking at internet delivery / applications specialist Akamai (AKAM). The company reports after the bell Wednesday and at-the-money front month implieds have spiked into the 90s and their highest readings in more than one and one-half years. Shown in Figure 1, we’ve annotated with a horizontal line, where implieds should conservatively, for a seller of premium, move to tomorrow on the heels of the report. This eyeballed estimate around 50% IV lines up with the middle of congestion in the last few months and where premiums fell to in the last event, as well as a couple prior spikes from earlier in 2011.

We can also see short-term premiums have on occasion moved aggressively below our conservative estimate. That would be a bonus of course to a strategy such as a short straddle, but the goal here is to commit to a position under realistic, not ideal conditions. Further, with longer-term 90SV of 57% and near the low end of its range of the past few months and shorter-term readings currently in the high 20s but seeing much more action in the 40s – 60s during this same period; logic dictates this estimate as fair. 

Figure 2: Akamai (AKAM) -6x ATM Feb 34 Straddles w/50% IV Crush

Doing some of the grunt work of looking at the historical post earnings reactions in AKAM, the past year has seen moves of -15%, -14.75%, -19% and most recently up 15.50%. These sizable moves also occurred on fairly large gaps. For a seller of the straddle this means being able to manage delta risk becomes a good deal more troublesome on top of the consistently large price reactions if history is to repeat itself.

But what about the bottom-line as it relates to the likes of a short straddle looking to capitalize on a crush in implied volatility? Above in Figure 2, we’ve priced 6 spreads for just under $4.00 using mid-market prices. We’ve factored in a 50% IV crush on today’s trade date.

The position maintains break evens some 11% to 12% away from the 34 strike and are basically the same tomorrow or at expiration as the report is close enough to force a near 100 delta into the 34 strike.  The push or breakeven is 3% to 4% below three of the four prior reports and 7% to 8% shy of the largest post earnings reaction.

History in relation to the current pricing seems to suggest the buyer of the straddle has the positional edge. But what if that trend breaks ranks tomorrow and shares don’t light up the Percent Leaders or Percent Decliners list on the NASDAQ and instead trade within our diagramed view? Bottom-line, at a minimum traders have a stronger understanding of where one's real risk lays when there’s still time on the clock and variables other than implied volatility, don’t turn out as planned.   

Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
Optionetics.com ~ Your Options Education Site
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.