How to properly price earnings implied moves?

julien.messias@uncia-am.com

*
*The High Growth companies specialist

When an earnings season arrives, many people try to think about smart strategies in order to limit the
risk or in order to earn money during this period. But earnings are casino, and it exists as many
interpretations as investors.
Post Earnings Announcement Drift, a Price Signal? By J. Messias
People like to have an idea of how much is the stock likely to move on earnings release, and by how
the much the volatility will drop on the news, in order to optimize the strike, or the maturity to choose.

Why the most commonly used calculations are wrong

Many banks or brokers provide such information, using the well-known ATM term-structure. But this
calculation ignores all the skew information.
Path-dependence is a big issue as well. When using ATM volatility, the ATM depends on a spot level, a
level that will not remain the same, after the spot move linked to earnings.
Therefore, a pure measure should be a measure which does not depend on the spot path.

Using Variance Swaps

Weekly options are particularly convenient for estimating earnings moves.

To make it simple, inputs are:
- ATM volatility for the next 5 or 6 weekly maturities, the first of these latter being the maturity
following immediately the earnings release.
- 90/100 moneyness skews on 3, 6, 12, 18 and 24 months, if they exists. The idea here being to calibrate
the skew pattern with respect to time, the shortest maturities being the most important for the
calibration, as we focus on less than one month smiles.
Hence a calibration is operated in order to get proxies for short maturity (1w, 2w..) on moneyness
skews, using cubic splines for example.

Below: term structure on linear (90-100) skew for GoPro

Since then, we transform these moneyness skews into loglinear skews and from now we only deal with
these latter. Our aim is to be able to capture the convexity of the smile.
(90 100) =

(90 100) 0.01

90
ln(100)

This transformation is inspired by the paper by Sebastien Bossu [1].

At this stage, we have for each short maturity an ATM volatility and a loglinear skew. Thus we are then
able to compute for each of these maturities a variance swap level by using the following formula:
3
2

+
+

2
2
4
(12
+ 5
2)
4

As stated by Bossu, this formula does not work for very steep skews.

Below: example of transformation from Vol ATM to VarSwap

As it can be easily noticed, the impact of skew on short maturities is pointless. But, with this formula it
is taken into account.
To extract the implied earnings move :
=

1
2
. { 2 . 1,2
. (1 1)}
252 0,1 1

2
0,1
:spot variance swap strike between now and first maturity after earnings release and call)
2
1,2
:forward variance swap strike between first and second maturity)

Assumptions:
-

Flat varswap term structure between first and second maturity.

The new spot will be the pivot point of the new backbone of the volatility surface.
This method works well for liquid stocks with weekly options.

Below: example of term structure before (blue) and after (orange) on GoPro

Should you be interested to receive weekly reports on US single stocks implied moves, contact the
author.

Below: example of a report

[1]Bossu S., Strasser E. and Guichard R., Just what you need to know about Variance Swaps