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A BAYESIAN APPROACH TO IMPLIED

VOLATILITY ANALYSIS OF S&P 500


Teik-Kheong Tan1, Prof. Dr. Merouane LakehalAyat2
1

Asia e-University
Kuala Lumpur, Malaysia
2
St. John Fisher College
Rochester, NY, USA

Abstract- Product innovation in the technology ecosystem can be enhanced through proper management of the supply chain. While
there are several strategies that technology investors favor for profitability during the earning cycles, one of the strategies utilized quite
often is the short strangle. A short strangle is an effective strategy with a theoretically unlimited risk. For example, Googles earnings
sent its share price up sharply by 13.8%, breaking the $1,000 barrier for the first time and increasing the companys value by nearly
$40 billion within a day. Such variations can be very costly for an investor who trades around earnings using short strangles. The aim of
this paper is to debunk this myth and demonstrate how a short strangle can be traded safely as long as certain requirements are met.
We will employ two companies in the technology sector to illustrate how our criteria can help in making better trading decisions. Since
the volatility crush is the key determinant for profitability, we modeled the crush between the implied volatility of the front and next
earliest expiration using Bayesian statistics. The accuracy of the Bayesian model is quantified using the Google stock as an example and
it is shown that the method is reasonably accurate even with sharp changes in volatility trends.

1. Introduction
By trading on corporate earnings, traders and investors can reliably profit from the markets in all directions while avoiding market
risk for the entire quarter. On the average, the turnover ratio of common stocks on the expiration date is 443% higher than other
Fridays on the earning week [1]. Since trading around earnings is a highly volatile event, the selling of strangles can be profitable
due to the volatility crush but this also comes with added risk. The study on information disclosures and their associated risks
have been a topic of extensive research since Ball and Browns [2] pioneering work. Some of these risks can be mitigated by
qualifying the trade appropriately. This is the focus of the paper. The aim is to carefully qualify potential trades based on certain
parameters that provide a margin of safety. There are several strategies that are known to be profitable in trading around earnings.
We will discuss one of them - the short strangle.
2. General Criteria for Short Strangle Application
We summarize the key criteria for applying a short strangle.
Liquidity, Volume and Open Interest: These 3 parameters are the most critical but are often overlooked (Truong and Corrado
(2014)). Liquidity refers to the tightness of the option bid/ask spread and is characterized by a high level of trading activity. The
minimum acceptable volume for the front month strike must be at least 500 and the open interest must be at least 1000. Ideally,
we would prefer the difference to be 1 cent and normally this is hard to achieve. If we are shorting a strangle, we will accept no
more than a 10 cent bid/ask spread.
Implied Volatility (IV): This is the estimated volatility of a stocks price. Many papers on forecasting IV have been published.
Some of the more common models use variable based asset pricing to determine equity and option pricing. A good coverage is
provided by Rossi [3] and Pastor and Veronesi [4]. Upcoming announcements create uncertainty in the option market prices by
increasing the premiums and this is reflected in the IV of the options. This phenomenon is well documented in Dubinsky and
Johannes [5]. However, up till now, there are no models that can predict IV perfectly, especially before earnings announcements.
The distortion in IV before earnings is what option traders capitalize on during quarterly earnings. Google reported its last
earnings on Oct 17th, 2013 and it turned out to be a blowout quarter. Without proper adherence to these criteria, there would be
substantial loss as highlighted in the Google example below.
Figure 1 shows that Googles Oct volatility is at 72.12% and the Nov volatility is around 32%. This is about 2.5 times
historical volatility. At least 2 times historical volatility is typically needed for a short strangle to be considered. Ideally, 3 to 4
times historical volatility is preferred, which may happen 5 or 6 times for each earning cycle. Given the criteria of at least 2 times
the historical volatility, this means that with the 2.5 times result, the criteria is met. We conducted a Bayesian analysis around the
differential IV for Google to ensure that the differential IV does not exceed the mean. We forecasted the IV trend for the current
week (where earnings are announced) as well as the next 3 weeks in order to observe the volatility crush. Our forecast is based on

observation of Googles earnings for the past two years. Since Google is still considered a growth company, its stock movement
characteristic should reflect as such. For example, based on historical earnings behavior, our expectation of the IV of Google prior
to earnings would be a normal distribution with a mean of 80% and a 50% probability of being between 65% and 95%. This
expectation is derived from historical earnings for the past 2 years for a high technology growth company. Table 1 below shows
the actual versus assumed IV. All options have a limited useful lifespan and every option contract is defined by an expiration
month or week. The option expiration date is the date on which an options contract becomes invalid and the right to exercise it no
longer exists. For example, in the Options Expiration column for Oct 13 (1) 100, (1) represents the number of days to expiration.
Since Oct 13 represents the regular options expiration on the third week of Oct, it also represents the number of days to the
options expiration on Friday for that particular week. The data chosen for the assumed IV reflects the most recent performance
(up till its most recent earnings announcement) of the prior quarter adjusted upwards by about 2%. Quarter 3 is generally
considered a strong quarter for Google (and other technology stocks) [6].
Table 1: Actual IV versus assumed IV for GOOG.
Expira
tion #
0
1
2
3
4

Options
Expiration
Oct 13 (1) 100
Oct4 13 (8) 100
(Weeklys)
Nov1 13 (15) 100
(Weeklys)
Nov2 13 (22) 100
(Weeklys)
Nov 13 (29) 100

Actual
IV
75.12
32.52

Assumed
IV
80.34
36.60

Actual Assumed
0.00
-4.08

Decision Point
Mean of
Distribution
80.00
75.16

26.24

28.53

-2.29

73.89

23.78

26.49

-2.71

73.13

23.32

24.86

-1.54

73.26

3. Bayesian Analysis
Before delving into the mechanics of our Bayesian analysis, it is worth highlighting the motivation for this method versus
classical inference. First, it is highly flexible and it allows the use of real market data to improve on the inferences. All the
inferences follow the same form from setting up the likelihood and prior distributions, then calculating the posterior by
conditioning on observed data via Bayes theorem. This is especially helpful in event driven days such as earnings where the
sentiment of the market towards risk (as reflected in the IV percentile) can shift dramatically before and after earnings are
announced. Often times, after the conference call, the management of the underlying company can further accentuate the move
during the extended hour trading session which results in a gap during normal trading hours.
Figure 2 shows the prior and posterior distributions for our Google IV differential forecast before earnings are announced.
First we consider the prior distribution. Rather than simply setting a uniform prior or using a linear approach, we looked back at
the historical IVs for Google for the past 2 years. Google reports its quarterly earnings after market close on Thursday of the
weekly expiration. This implies there is only 1 day before options expire for that week. However, the historical IV of Google
suggests that the following 1 and 2 weeks after earnings also experience a similar rise in IV (although not as pronounced). This is
shown in Table 1. Rather than setting a uniform prior across models, we select a uniform prior across volatility differences
between expiration functions. This column is labeled as Expiration # in Table 1. In other words, let the prior be proportional to the
historical weighted average of Google for prior 8 quarters (2 years) with bias towards the last 3 quarter. To estimate this, we
consider the parameter range of integers between 10 and 205, inclusive, and calculate the prior probability and maximum
likelihood respectively. We repeat this with data for the next 4 weeks. We select an appropriate mean (in our case 80 percentile)
as the highest volatility reached just before earnings are released. We do not forecast just 1 point. We allowed for our uncertainly
by forecasting a probability distribution. In this case, we expect the highest volatility for Google just prior to earnings release
would be distributed in a bell curve with a mean of 80% and a 50% probability of being between 65% and 95%. We selected a
time horizon of 4 weeks with the week of earnings release modeled as week 0. The first computation is to determine the
lognormal parameters for the mean and standard deviation [7]. The mean of the natural log of the forecasted IV, in terms of
forecasted mean T and standard deviation , is computed as

1
T

ln T 0.5 ln

(1)

where T = 80 and = 15/0.666.


The standard deviation of the natural log of the IV, in terms of the forecasted mean, T and standard deviation is computed as

' ln 2 1
T

(2)

The computation for the linear parameters such as the mean and standard deviation are as follows. The mean is obtained by
summing the products of the IV (between 10 and 205) and the corresponding posterior probability of expiration week # (where #
= 1, 2 and 3). To understand how IV crush can be helpful in deciding the appropriate options strategy, we need to understand the
key assumption made by researchers who build volatility differential models: the statistical distribution of the IV. The two most
common types used are the normal and lognormal distributions. The normal distribution gives equal chance of volatility occurring
either above or below the mean. However, it is more common for market participants to use the lognormal variety. Hence, we will
use the lognormal distribution parameters to generate our probability distributions. The decision point for our studies depends on
the mean of the distribution. If there is a significant deviation between the actual and the assumed for expirations 1, 2, 3, and 4, it
would indicate that the strangle is too close to the expected move, which gives standard deviation of 1. Statistically, the IV is a
proxy for standard deviation. By comparing the posterior distribution curves after week 1, 2 and 3 with the prior distribution, we
note that the middle sections of the posteriors are well within that of the prior. Based on this Bayesian analysis, we observed no
anomaly in the third quarter Google earnings from a differential implied volatility perspective. However, the next section on
premium collection indicates a premium that is insufficient if we are to observe the expected move criteria.
Premium collection for GOOG: The expected move to the upside is $32 which is around $920. If $35 is subtracted from the
$888 price point, the price would be around $856. Hence, $856 - $920 is the expected move range. This will be reflected in the
strangle and a determination is made from here. If $920 is selected on the CALL and $855 on the PUT, it shows a credit of $8.30
(Figure 3). However, the credit is insufficient. At the current price of $888, 1% of $888 is $8.88. In this case, the credit of $8.25 is
just over 1%. In order to meet the 2% minimum acceptable credit, at least $18 is required. If the strikes are changed to $905 and
$870, it gets closer to the 2% minimum credit (Figure 4). However, this is 3 strikes closer, which is way too risky and violates the
1.5 times outside the expected move criteria. An analysis of the expected move range is indicated in Figure 5. The position is
outside the expected move range but only by about 1.1 times. As stipulated earlier, the requirement is at least 1.5 times outside the
expected move range. Based on current numbers in Google, it would not meet the criteria for a short strangle. As it turned out,
Google reported earnings on Oct 17, 2013 which exceeded the expected move by $56 to the upside! (Figure 6). After the bullish
earnings conference call the following morning, the stock price increased further resulting in closing price of around $1010. This
3.8x increase in expected move annihilated many traders who sold strangles without following the criteria outlined above.
Adherence to the criteria would have saved at least $9,000 per contract for the trader. Googles stock price has never looked back
since then and is currently (Jan 10, 2014) trading at around $1130.
Undefined Risk: Selling a strangle can be a daunting exercise because it has unlimited theoretical risk. How can the potential
capital per spread we are risking be estimated from a probability perspective? Table 2 shows a buying power effect of $24,125.
Essentially, this indicates risking $24,125 to potentially making $905. The objective is to take advantage of the inflated IV going
into earnings event by being a net seller of that volatility premium inflation and hoping that the stock stay within the range and all
of the increased volatility premium inflation decays overnight.
When the decay normalizes, for example in Google, where it gets up to 75%-80% IV, and then the following morning after
earnings, in the first 30 minutes of trading, it normalizes to about 35%. This roughly represents a 50% reduction in volatility
premium overnight. By being the net seller of that volatility premium, one is selling the volatility premium at inflated prices and
hopefully buying them back after the volatility crush has taken place the next day.
4. Extension to Other Technology Stocks and Future Work
We have further tested our analysis on the EBAY stock to confirm the soundness of the above criteria for technology companies.
Due to space constraint, we have omitted the results. Our future work will involve developing more elaborate models to compare
with the Bayesian method of analysis as well as testing our analysis on more stocks with different volatility trends.
5. Conclusions
Selling a strangle may not be as risky as portrayed by the investment community. It can achieve a high probability of success
provided certain criteria are met. As long as the specific criteria/parameters are in place and adhered to, success in selling
strangles into earnings is almost assured. The criteria for qualifying a short strangle during earnings seasons are listed as follows:
- Liquidity, Volume and Open Interest must be met.
- The IV differential should be 2 times or greater than historical volatility.
- Avoid stocks that have a tendency to make huge moves in the past on earnings.
- Buying power effect is significant in comparison to the portfolio status.

- Min acceptable credit should be 2% of the stock price.


- The lower and upper breakeven thresholds should be 1.5 times or greater outside the expected move range.
Bayesian statistical analysis provides a useful model for the IV behavior of the earnings for the front week and subsequent 3
weeks. The accuracy of model has been quantified using the Google stock. It has been shown that even with sharp volatility
trends, the method is reasonably accurate. Maintaining a mechanical approach towards selling strangles takes the emotions out of
the trade, which results in better chance of success. We have demonstrated how the criteria can keep us mechanical if they are
followed strictly.
Table 2: Buying power effect

References
[1] C-H Chiang, The Impact of Option Expiration and the Timing of Earnings Announcements on Stock Returns and Trading Volume,
Doctor of Philosophy Thesis, Graduate School of Arts and Sciences, Columbia University, pp. 3 - 4, 2010.
[2] R. Ball and P. Brown, An Empirical Evaluation of Accounting Income Numbers, Journal of Accounting Research 6, pp. 159 - 178, 1968.
[3] A. Rossi, The Britten-Jones and Neuberger Smile-Consistent with stochastic volatility option pricing model - a further analysis,
International Journal of Theoretical and Applied Finance, 2002.
[4] L. Pstor and P. Veronesi, Technological Revolutions and Stock Prices, American Economic Review, American Economic Association,
vol. 99(4), pp. 51 - 83, September 2009.
[5] M. Johannes and A. Dubinsky, Earnings Announcements and Option Prices, Graduate School of Business, Columbia University, June 2005.
[6] G. Pupo, The Bull and Bear Tech Stock Report, 4th Quarter 2013 - TSR-1013, The Tech Stock Report Oct 2013, pp. 1 - 3.
[7] Truong, C., & Corrado, C. (2014). Options trading volume and stock price response to earnings announcements. Review of Accounting
Studies, 19(1), 161-209.

Figure 1: Google options chain.

Figure 2: Bayesian probability distributions for Google IV differential. The x-axis represents the IV percentile and the y-axis the
probability. The 80% IV percentiles of the posterior distributions are well within the prior distribution.

Figure 3: Credit from selling Google strangle at strikes of $920 CALL and $855 PUT is $8.30. This is still outside the expected move.

Figure 4: Changing the strikes to $905 and $870 increases the credit to $17.70. However, this increases the risk (3 strikes closer) and
falls within the expected move which violates our expected move criteria.

Figure 5: Risk profile for short strangle on Google. The x-axis represents the stock price and the y-axis the profit. The red line shows
profits and losses at expiration (after 4 days in the example above) while the white line (lighter shade) shows profits and losses at the
current date (Oct 17, 2013). Even though it passes the criteria for premium collection, however it falls inside the expected move ($32).
To compute the expected move, we subtract $32 from closing price of $888 for the PUT strike and add $32 to closing price of $888
for the CALL strike.

Figure 6: Google gaps up by $88 after earnings.

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