In liquid underlying's the price of the options before earnings are driven by supply and demand. Let's say a non liquid underlying before earnings. Where only 100 contracts are sold. How do market makers price the earnings event vol?
The aggregate view of all the market participants is reflected in the price it is not something the market maker is pricing they take market prices and based on market prices offer other options at a price that is reflected synthetically along the options chain somewhere else.. so if your pricing an out-of-the-money 20 Delta call you a look at the price of the 20 Delta put and the bid and the ask on the underlying to create a conversion.. a market-maker is typically not going to take directional Delta risk...
Can we break this down a little further? Let me give you a real life example to give it context. Today DXC traded 2,700 options today. It just had it's earnings. The avg absolute moves over the past 10 quarters is 3.87% yet the front month option was pricing in a 7% move. I was able to sell the 100 straddle for 8.30. So the market maker was looking at what to price it? He obviously was not looking at the historical moves because than he would of priced it lower and sold the next month to hedge. Thanks for the response
MMs don't "price" options in that sense. Supply/demand in the marketplace does. MMs quote those market values ±ε.
It's not really a supportable assumption that the current quarter move would be related to the average move over the last x quarters for several reasons. First, averages. It's possible the stock moved almost zero for 9 of those quarters and 40% in one of them. It's the shape of the distribution that matters, not the average. Averages are a very dangerous thing in many situations, this being one of them, so if you ever find yourself supporting something with the phrase "the average..." stop and think about it. Second, even if you had a very tight distribution, the current volatility of the market has a significant impact on the volatility of the stocks in that market, especially high Beta stocks. So it could be (actually is) that volatility was lower in general for most of the past 10 quarters than it is today. Finally, it's possible that an idiosyncratic event in the past quarter makes it harder to predict earnings. Maybe the company started a new product line that could be a bust or a big success and the market isn't sure which it will be as opposed to business as usual the past 10 quarters. Or maybe they stopped giving earnings guidance. Or attempted a turnaround. Or any number of other similar issues. Bottom line is that I'd question the premise of the question itself.
Hey sig thanks for the reply. So I have purchased data that gives me the last 50 quarters of company's price move, estimate and surprise. I also get the Monthly return leading into earnings, weekly returns, and daily return right before earnings. After running regressions on MANY companies here is what I found. Earnings surprise has very little correlation to stock move after earnings, I can put up multiple graphs of you do not believe me. Also the volatility before earnings has no correlation to the earnings move. In fact I have applied multiple linear regression models, autocorrelation models, garch models to earnings moves and NOTHING correlates. HOWEVER 70% of the companies returns after earnings are normally distributed with a kurtosis of 3!!! When I said average i meant to say first standard deviation. Have you found any correlations between earnings returns an a variable or variables? That would help alot thanks sig!!!
I also want to mention that higher implied vol before earnings does not do a good job at predicting returns. In fact when there is very low impliedvol you often see larger moves.
You may want to separate stocks into different buckets, positive and negative earnings surprise, growth vs value stocks. There is definite correlation between negative earnings surprise and future stock prices, especially growth stocks.