Option Smile Volatility and Implied Probabilities: Implications of Concavity in IV Curves

Researchers:

John K.E. Markin
Darsh Kachhara
Astha Astha

Supervisor:

Dr. Dan Pirjol

Abstract:

Earnings announcements (EADs) are important corporate events for investors and can result in increased stock price volatility. A study using short-term options data found that bi-modality in the risk-neutral distribution and concavity in the IV smiles are common characteristics before EADs. The study compared returns between concave and non-concave IV smiles to determine if the concavity in the IV curve provides information about market risk and how investors hedge against extreme volatility during EADs. The study found that investors pay a premium to hedge against uncertainty caused by upcoming announcements in the presence of concave IV smiles.

Results:

To understand the concavity impact in implied volatility smiles and the resulting bi-modality in risk-neutral distribution, the last seven quarters of seven companies beginning in 2021 are examined. 40% of the sample had concave IV smiles before the earnings release.
1. Blackrock (BLK)
Despite experiencing a correction one day after the announcement, the stock had a positive overall outcome. The IV smile for the next immediate expiry has returned to its convex shape, indicating a positive shift, although there is still some uncertainty in the longer maturities. The previous contract expired on the announcement day, leaving the immediate expiry with 7 days left.

2. Alphabet Inc (GOOGL)

For Alphabet, we witness a concave IV smile in 4 quarters out of 7. Alphabet, a behemoth in this industry, would be sensitive to these risks. The quarter where the concave IV smile and bimodal risk-neutral distribution were the most prominent was Q2 2022.

3. Meta Inc (META)
Meta has a concave IV smile in 5 out of 7 quarters due to its shift to virtual reality/augmentation, which is costly. The stock has dropped by about -62% in value since the beginning of 2021 (till Q3 2022) and the price-to-earnings ratio for the same time period has declined by over -50%. The Q3 2022 earnings report showed lower-than-expected earnings per share. Q3 2022, this quarter witnessed the highest negative jump, where prices fell by -33%.

4. Netflix Inc (NFLX)
Netflix has 6 concave IV smiles out of 7. Most of these concave smiles were followed by significant jumps ( or drawdowns) in the stock price. Netflix faced competition from platforms such as Disney+, HBO max and Amazon prime, and saw significant drops in subscribers in Q4 2021 and Q1 2022. . The massive drawdowns after the Q4 2021 announcement and Q1 2022 announcement were brought on by the loss in subscribers worldwide. Netflix announced in early 2022 that it expects to lose close to 2 million subscribers.

5. Walgreens Boots Alliance Inc (WBA)
Walgreens Boots Alliance corporation has been facing stiff competition from CVS. The pharmaceutical giant has been witnessing slow growth in revenue and some unimpressive quarters. The stock price has lost (till Q4 2022) -29% value since the beginning of 2021.

Implications of Concave IV Curves
This paper examines the potential of concave implied volatility (IV) curves before earnings announcements to forecast stock price movements. Evidence suggests that large stock price movements often occur around earnings, and concave IV curves can provide an ex-ante forecast for identifying where these movements are more likely to occur. The paper aims to isolate the magnitude of the returns on earning announcement day for concave and non-concave IV curves, assuming there is no cost to trade these assets.

Formation of Straddles and Implications on IV Curve

Formation of Strangle and Implications on IV Curve

Characteristics of Option and Price Data for Quarterly Earnings Announcement (2021 -2022)

Characteristics of Concave vs Non-Concave IV for Quarterly Earnings Announcement (2021 -2022)

Conclusion:

The study finds that stock options' IV smiles commonly exhibit concavity before earnings announcements (EADs), which disappears after the announcement is made. This indicates a bimodal risk-neutral distribution for the underlying stock price, enabling investors to predict announcements that will cause larger-than-average stock price swings. The study also reveals that investors will pay a significant premium to protect against this event risk, affecting options pricing and resulting in a concave IV curve. The study suggests that the curvature qualities of the IV curve offer significant information about event risk pricing and asset price behavior and could be investigated in future research.