Earnings crush, term structure and skew

Implied volatility is not one number per stock. It varies by expiration and by strike, and both patterns are worth reading. The most vivid demonstration is what happens around an earnings report, so that is where this lesson starts.

The earnings crush, worked through

XYZ reports earnings after the close on Wednesday. It is Monday; the stock is at $50.

Two weekly expirations are listed: this Friday (5 days, includes earnings) and next Friday (12 days, also includes earnings). The 45-day monthly also includes it. The relevant chain, ATM:

The 5-day straddle at $4.55 says the market expects XYZ to move about 9% on the report. Almost all of that price is the event; on a normal week the 5-day straddle would be closer to $1.75 at 30% IV.

You buy the 5-day $50 call at $2.30 because you think the report will be good. Thursday morning XYZ opens at $53, up 6%. Here is what happened to your call:

You made $0.95 per share on a 6% move in your direction, because the extrinsic value collapsed from $2.30 to $0.25 as IV fell from 78% to 28%. That collapse is the IV crush. If XYZ had opened up only 4%, at $52, the call would be worth about $2.15 and you would have lost money on a correct call.

Now suppose you had bought the 5-day $50 put at $2.25 as a hedge and XYZ had opened at $53. The put is worth roughly $0.05. Loss $2.20 per share, the entire premium bar a nickel.

What the market got right

The straddle said "about 9% move expected". XYZ moved 6%. The market overpriced the event, and anyone who sold the straddle at $4.55 could buy it back Thursday for about $3.30 (call $3.25 plus put $0.05), a $1.25 profit. Had XYZ moved 12%, the straddle would have been worth about $6.00 and the seller would have lost $1.45. Selling earnings straddles is a bet that the realized move is smaller than the implied one; historically it has been, on average, by a modest margin, with a fat tail of exceptions.

Key idea: Before a scheduled event, IV in the expiration covering it inflates to price the expected move; after the event, it collapses in minutes. Long options through earnings need the stock to beat the implied move, not merely to go the right way.

Term structure

Term structure is IV plotted against expiration. Three shapes:

• Normal (upward sloping): near-dated IV lower than far-dated. Reflects that near-term movement is more predictable and that far-dated options carry a premium for unknown unknowns. Typical in calm markets.
• Inverted (downward sloping): near-dated IV higher than far-dated. Happens when the market expects something soon: an earnings report, a regulatory decision, a macro announcement, or a general panic that is expected to subside.
• Humped: IV highest in the expiration containing a known event, lower on either side. The earnings table above is a hump at 5 days.

Reading it: if you want to buy an option on a stock with an event, buy an expiration that lands well past the event, so that the post-event crush hits a smaller share of your premium (the 45-day option in the table has IV of 41%, not 78%, and will drop to about 30% after the report, a loss of 11 points × vega rather than 50 points × vega). If you want to sell the event, sell the expiration that contains it and nothing more, because that is where the inflated premium sits.

Skew

Skew is IV plotted against strike for one expiration. On equity indices and most stocks, OTM puts trade at higher IV than OTM calls:

The 10-delta put carries 42% IV; the 10-delta call carries 28%. That is not an error. Stocks fall faster than they rise, crashes cluster, and investors holding stock pay up for downside protection. The result is that OTM puts are systematically more expensive in volatility terms than OTM calls at the same distance.

Two practical consequences:

• Selling OTM puts collects more premium per unit of delta than selling OTM calls. That is why put-selling strategies (Module 7) are more popular than call-selling ones on indices, and also why the losses in a crash are bigger than the premium suggested.
• Delta as probability is distorted by skew. A 16-delta put's model probability is computed at the put's own elevated IV, which makes it more likely to be touched than a 16-delta call. Treat OTM put deltas as slightly understating the true chance of trouble.

On some underlyings, notably commodities and stocks with takeover chatter, the skew flips: OTM calls are richer. Always look at the chain rather than assume.

Putting the three together

Before any premium trade, three questions:

1. Is there an event in this expiration? (Hump in term structure.) If so, is the implied move reasonable relative to past reports?
2. Is IV high or low for this stock? (Rank and percentile, previous lesson.)
3. Which side of skew am I on? (Selling puts collects a skew premium and carries crash risk; buying puts pays it.)

Try it: Find a stock with earnings in the next two weeks. Record the straddle price for the expiration covering the report and compute the implied move as a percentage. After the report, record the actual move and what the straddle was worth at the open. Do this five times over a quarter and you will have your own data on whether that market overprices events.

Recap

• IV in the expiration covering an event inflates before it and crushes immediately after; long options need the stock to beat the implied move.
• The ATM straddle price is the market's expected move; compare it to the stock's history of actual moves.
• Term structure is IV by expiration: upward in calm, inverted in stress, humped around a known event.
• Skew is IV by strike: OTM puts usually carry higher IV than OTM calls, so put sellers are paid more and delta understates downside risk.
• Ask about event, level and skew before every premium trade.