As a stock's earnings announcement date approaches, market participants begin to speculate on the price of the stock after earnings by purchasing options. This causes implied volatility to increase. However, when looking specifically at the implied volatility of the nearest options cycle that includes earnings, a phenomenon occurs that makes it appear as if option premium is exploding.
More specifically, the market prices in a certain expected move for a stock's earnings move. For example, the market might price in a 5% expected move on a $100 stock, or a $5 expected move for earnings. A majority of the earnings trades will take place in the nearest options cycle that includes earnings, which is why we focus on this cycle. If there are 5 days left until the expiration of that cycle and the market is pricing in a 5% expected move, that will give us a certain implied volatility number.
If the market's expectations haven't changed about the earnings and the expected move is still 5%, but only two days remain until the expiration of that cycle, we will observe a significantly higher implied volatility in that cycle. This means that the option prices didn't change, but the implied volatility increased. Understanding this can help you understand why buying options leading up to a stock's earnings is not a slam-dunk trade.
Join Tom Sosnoff and Tony Battista as they discuss this topic and add their own insights!
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