Does implied volatility always rise as earnings announcements approach?

Question

Often, implied volatility of options rise as an earnings announcement approaches. Does this principle hold true regardless of whether the earnings are expected to be good or bad?

Also, usually IV and price of the underlying are inversely related to each other. Is it fair to say that this inverse relation does not hold around earnings?

I mean, if earnings are expected to be good, the price will rise, but so will the IV, right? EDIT: I am talking of the IV of the ATM call/put ,which is expiring within a week of the earnings announcement

Answer 1

Changes in implied volatility are caused by many things, of course, and it is tough to isolate the effect you are describing, but let's try to generalize for a moment.

Implied volatility is generally a measure of how much expect uncertainty there is about the future price of the stock. Uncertainty generally is higher in periods including earnings announcements because it is significant new information about the company's fortunes can make for significant changes in the price.

However, you could easily have the case where the earnings are good and for some reason the market is very certain that the earnings will be good and near a certain level. In that case the price would rise, but the implied volatility could well be lower because the market believes that there will be no significant new information in the earnings announcement.

Answer 2

Implied volatility rises when a company has pending news that could move the stock's price. It also rises when a stock is trending.

The expectation of a good or bad earnings number is secondary. The root cause of this is that traders are bidding up option prices (demand) because they believe that share price may move significantly.

The amount of IV expansion may be significant if it's a popular stock (FAANG) with a higher beta. OTOH, low volatility stocks like utilities and REITs may see little to no IV expansion pre earnings.

Arbitrage strategies (conversion or reversal) link the prices of same series options. If the implied volatility of the put changes, so does call, and vice versa.

IV and price are not inversely related. GOOG at $1,100+ has the same IV as 100's of other stocks that trade at any other price. Today, the Composite IV of Google and Lennar Corp are almost identical and yet GOOG is $1,080 higher.

Answer 3

Note that the actual volatility is directly affected by changes in knowledge. The implied volatility is directly controlled by investor expectations, and those are affected by expected events, so the implied volatility is indirectly affected by earnings reports. Actual volatility is a parameter, implied volatility is a measured statistic.

If either good news is certain, or bad news is certain, then volatility will not increase. The less certain the news is, the more volatility increases, regardless of whether the uncertainty is of the form "probably good news, but might be bad" or "probably bad news, but might be good".

However, "volatility" is a single parameter. It is used in models such as Black-Scholes that treat the spread as being characterized by a single parameter. Events like earnings reports tend to make Black-Scholes less valid, as Black-Scholes is justified by treating stock prices as a random walk that tends towards a normal distribution due to the Central Limit Theorem. When one event such as an earnings report is dominating a period, the Central Limit Theorem, and thus Black-Scholes, has reduced validity. While volatility just measures the variance of the spread, large events can make other parameters, such as skew and kurtosis, important considerations. In some cases, earning reports can create bimodal distributions of expected price.

As an example, suppose a stock has 90% probability of going up $1 and 10% probability of going down $9. Normally, a call and put options are roughly symmetrical on short time periods; a put option with a strike price $2 below the spot price costs about the same as a call option $2 above the spot price. But here, a put option $2 below the spot price is worth $0.70, while a call option $2 above the spot price is worthless. Just looking at the volatility, there would be no way to know this; while the relative value of puts and calls depends on whether it's "probably good news, but might be bad" or "probably bad news, but might be good", volatility does not.