Monday, April 12, 2010

Implied Volatility and Earnings

Earnings season is upon us and is harkened by this evening's release of Alcoa, Inc.'s (AA) numbers. The question traders are asking is: What impact will the earnings release have on the price of the stock? Well there is a quick and dirty method for estimating this and it works particularly well on expiration week (which this week is for those who weren't paying attention). Take the front month implied volatility of the at-the-money options and divide by the square root of time. What?

Let's use AA as our example. AA closed on Friday at $14.39, which isn't conveniently right at a strike, but since AA options have strike in $1 increments we can use an estimated average of implied volatility for the 14 and 15 strikes on the April options. Obviously, stocks are seldom right at a strike so the simple averaging of the two surrounding strikes is a good way to go. If you want to get really fancy you can calculate a weighted average, but that kind of defeats the quick and dirty part. So the average implied volatility for these strikes as of Friday's close was approximately 65%. It's important to remember that that is an annualized number. To convert that into the a daily expectation we need to divide that by the square root of time, which in this case is the number of trading days in a year. Generally there are about 250 trading days per year and √250 = 15.81, but 16 is good for quick and dirty and is also much easier to remember. 65%/16 = 4.06% or roughly $.58. Note that there is no directional implication.

Now there are three important points to keep in mind. First, the calculated value is based on Friday's close, a better estimate can be made when as we approach today's 4 PM close. In other words do the math again around 3:30 PM, since there is likely to be some active trading in these options ahead of the earnings report which will obviously impact the implied volatility value. Second, know what the number means. Implied volatility is the boundary of the first standard deviation, meaning that if you could repeat this particular earnings release 100 times, 67 of those releases would impact the stock by no more than + or – 4% and 33 of those releases would result in a gain or loss in value of more than 4%. Finally and probably most importantly, is the trend in volatility. It's a good idea to know whether both actual and implied volatility has been rising or falling over the last several days to get a feel for what expectations are out there. Unless you have been following the options for a few days it is hard to know this, however you can get a pretty good estimate for an individual stock at . But it is really about the last minute action ahead of the numbers, so looking at the 3:30 PM calculation compared to Friday's calculation may be sufficient.

In summary, the average implied volatility of the at-the-money strikes divided by 16 will give you a range of potential impact of the earnings release. While we are using this method for estimating the impact of an earnings event, you can use it whenever there is an impending event that could have an immediate impact on a stock.

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