What’s it mean when you come across a trader or analyst chatting up their view on what to expect from a company’s earnings release? It could mean a whole lot of nothing of course, but if the dialogue is related to the company’s option prices, straddle or strangle markets in front of the report, it may be worth paying attention too.

In a featured Back to Basics piece “Earnings Expectations Part I” we began our investigation of this question and covered two methods of interpreting this pricing phenomenon. Discussed first was the most often used strategy by novice’s and pros alike, the at-the-money straddle market with focus on the non-directional spread’s breakeven analysis at expiration when the earnings event has very little time left until expiration.

Secondly, we addressed earnings expectations with a slightly more learned eye by taking the sum of the at-the-money straddle and surrounding-money strangle, then dividing by two to yield a slightly more robust estimate of trader expectations.

Today’s discussion will highlight the use of the bell curve as a guide. We’ll finish up this series later this week when we look to figure out what the other guy or gal could be pricing in for the earnings event by exploring a slightly looser method involving a likely volatility crush scenario for the fast money crowd when there’s time on the calendar but not on the trader’s hands.

The first of the two methods assesses trader expectations or collective opinion by examining implied volatility using the bell curve and its associated probabilities using standard deviation analysis. This is possible as option pricing is founded on the principle of implied volatility tied to a 1 standard deviation calculation or degree of confidence of 68% on an annualized basis.

In order to take raw implied volatility data and figure out what this pricing means regarding earnings expectations and movement in the underlying for this shorter period, traders can look to use the following steps:

• Divide yearly calendar days by days until expiration: 365 / x = y
• Take the square root of “y”
• Divide current implied readings by step 2 to yield percent move estimate.
• Multiple step 3 by underlying share price to determine up / down price range estimated at 1SD confidence

To use a current illustration of what the bell curve is telling traders, let’s look at Amazon (AMZN) which reports after the close Tuesday night. With shares at around 192.25 and midway between its 190 and 195 strikes, those markets represent at-the-money implieds, which on its well-traded Weeklys February contract amount to pricing roughly around 107% IV.

Open interest is far smaller in the Weeklys compared to the regular February, but fairly even trading between the two contracts does show plenty of short-term positioning obviously interested in the purest earnings play on the board. With that in mind and four days until expiration:

• 365 / 4 = 91.25.
• Square root of 91.25 = 9.55
• 107 / 9.55 = 11.20%
• 11.20% x 192.25 = +/- $21.50 or range of $170.75 to $213.75

Figure 1: -1x Weeklys February 190 Straddle Amazon (AMZN)

The resulting range of $170.75 to $213.75 tells us how traders, through their efforts at affecting implied volatility, are pricing in a 68% or roughly two-thirds chance of AMZN shares remaining within this defined 43 point area through expiration.

Shown above in Figure 1 we’re looking at -1x Weeklys February 190 straddle. Expiration break-evens of about 172.50 and 207.50 are tighter than our calculated expected range. This has to do with nuances of constant hedging during the period and which we’d estimate to be of benefit to the trader short the straddle. Now and with this information in hand, the question of how this pricing might stack up to past reports earnings reactions might be compared; if traders are looking to gain a positional advantage based on history repeating itself.

Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
Optionetics.com ~ Your Options Education Site
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.