7. Trading the Earnings Cycle

Quarterly earnings create tremendous opportunities for option traders. For stocks that have a history of large earnings-associated price spikes, the market tends to overprice options by setting implied volatility too high. The distortion is especially large when an earnings release coincides with options expiration. For these stocks, implied volatility rises sharply to offset the rapid time decay of the final few days of the expiration cycle.

A second distortion occurs just after earnings are announced and volatility collapses back to an appropriate level. The rate of collapse depends on the magnitude of the price spike. When the spike is much smaller than implied volatility would suggest, the collapse is very rapid—sometimes just a few minutes long. However, when implied volatility accurately anticipates the magnitude of the spike, the collapse occurs over an extended period of time that can last from hours to days. This effect is exaggerated in cases where the stock continues to move in the direction of the spike.