Earnings IV Glide Path

I want to expand briefly on Wednesday’s HOOD: A Case Study in “Renting the Straddle” because HOOD’s implied volatility that contains earnings actually declined for the rest of the week and disentangling that is a good chance to reinforce your understanding.

On Wednesday, Feb 13th HOOD vol (which encompasses earnings on Feb 10) lifted a bit from when I wrote the post. We’ll call it 68% IV.

To make 68% IV fit smoothly with the non-earnings vols from the preceding expirations, we need to assume an earnings move that allow the ex-earnings vol to be ~56%

That corresponds to about a 9.5% earnings move (a bit higher than the average move of 8.55% for the past 8 quarters).

This table shows implied trading day IVs net of various-sized expected earnings moves.

Let’s tie this idea back to theta or option time decay.

A one-day move of 9.5% corresponds to a single-day implied vol of ~119%

9.5% / .80 = 119%

This comes from remembering that an ATM straddle is 80% of the implied vol

As you approach the earnings day, the implied vol of the option will be dominated by the fact that the stock is expected to move 9.5%. Therefore, we know the implied vol is going to increase.

We think of theta as “how much value the option loses as time passes” but because we know that vol is going to steadily rise, we can conclude that the actual experience of theta is going to be much less than the model says. The model doesn’t “know” the implied vol is going to increase, but you do.

As vol increases, the option will gain value that offsets some of the theta. It won’t offset all the theta. If it did, then you would just buy all the options today, have free gamma for a month, and sell them right before earnings.

So much of the theta will be offset?

We can answer this if we hold our assumptions constant:

• trading day IV is 56%
• earnings move is 9.5%

(I added the assumption that the earnings date is also the expiration date. It’s stark that all the theta we defer happens on the last day.

You can see how the vega offsets part of the theta.

Just like with any option, the theta still accelerates as you approach expiry but at a slow rate (theta is left axis).

All the theta happens at the end.

Oh, as a matter of pragmatism, I should add that HOOD option markets are wide. And yet there’s millions of contracts of open interest! Amazing for market makers. To quote Alanis…isn’t that ironic?