Saturday, July 19, 2008

Implied Jump for stocks Before an Important Announcement

I always used to wonder how much jump in prices is the market really implying right before an earnings or another important announcement. My research regarding the concept led me to this book " Volatility Trading" by euan sinclair. There he clearly shows how to calculate the implied jump in the stock by options prices. The Strategy is to sell the options so that one can take advantage of the fact that implied volatility usually drops after an announcement. So we will be basically short volatility. one should also expect that the front month implied volatility should be greater than that of further expiration implied volatility.

First, assuming, sigma_1 as the front month implied volatility and sigma_2 as the second month implied volatility, forward volatility,

sigma_12 is given by

The volatilty attributed to the event is the difference between front month volatility and forward volatility.

Sigma_E =

The Expected Jump is :

A Trader needs to compare this estimate to that of his own estimate of how much the stock is going to jump after the announcement and should trade accordingly. Not definitely for the faint hearted.


Fred said...

We look at the implied volatility skew between the front-month and the 2nd term options to get an estimate of what the market expects in terms of an earnings-gap move. It isn't perfect, but gives a reasonable estimate.

Fred Ruffy

van winkle said...

so, this formula gives the expected jump as percentage of the stock price?

TradingwithMatlab said...

van wrinkle: It gives how much percentage the stock is expected to jump from now to the next month. This is in terms of percentage.

taylor said...

What are the Ts? expiration date? i don't think i understand what format they go in as.

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