A reader asked for some more details about how I use implied volatility (IV) and/or historical volatility to help identify companies with a high potential to spike following an earnings announcement. Specifically, she was looking at the 17% gains in Schnitzer Steel (SCHN) today and wondering if IV could have tipped her off to the probability of a big move.
- Yahoo Finance, Google Finance, and other data providers sometimes list betas of 1.0 for issues they apparently have not calculated a beta for, particularly newer issues and foreign stocks
- highly volatile stocks that go in the opposite direction of the market for awhile can sometimes have low betas -- think small oil/gas exploration companies, gold miners, etc., but also consider that some tech stocks may countertrend for a long period and thus acquire a smaller beta than their volatility would suggest (historical volatility would be a better number to watch here, because it focuses entirely on the magnitude of the moves and does not care whether these moves are correlated to the broader markets)
- implied volatility is forward looking, so it automatically adjusts to account for scheduled earnings announcements, a pending FDA drug decision, a legal issue that is due to be resolved, buyout rumors, terrorism, violence in the Middle East, a hurricane that is bearing down on the US, etc.
Getting to the meat of the question, since I am looking forward in time to earnings, I pretty much ignore historical volatility and focus entirely on IV. I usually try to target the top 10% or so most volatile companies that are due to report in a 24 hour period, so that if it is mid-June and there are very few reports, I might look at IV as low as 35 (I generally consider 40 to be a minimum IV), but by the end of July to early August earnings peak, there will be so many small and extremely volatile companies reporting that it might be possible to screen out all companies with an IV below 50. Also, once you get over about 60 or so, I am not sure that a higher IV really translates to incremental future volatility in the short-term (unless we stray from earnings and talk about FDA decisions, etc.)
Regarding specific numbers, I use the current IV Index call number (the 44.20% from the SCHN iVolatility link), but the current IV Index put and current IV Index mean are usually so closely correlated that it doesn't matter which one you pick -- as long as it is a current number.
I also recommend that readers consider looking not just at the raw numbers but also at the 12 month volatility charts (such as this iVolatility chart for SCHN) where it is often much easier to visualize the size of the current pre-earnings volatility run-up – and also compare it to similar up-trending volatility patterns that preceded earnings in the past few quarters. In the case of SCHN, you can see a big jump in volatility during the past week and a sustained move since about mid-April. Implied volatility may not have been screaming “Buy!” in an unambiguous manner, but one can reasonably argue that at an 11 month high just prior to this morning’s earnings announcement, it was warning of the increased possibility of a big move in one direction or the other.
Finally, I would be would be remiss in not reiterating that directional earnings plays are highly speculative and usually carry a formidable risk/reward profile, so I recommend that anyone who plays the earnings lottery considers limiting their exposure with an options play or by making a bet on volatility instead of direction, as volatility typically – and much more predictably – decreases 15-20% the day after earnings are announced.