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

TL;DR

This paper investigates how concavity in implied volatility smiles around earnings announcements signals market risk and influences investor hedging behavior, revealing that investors pay premiums for hedging against earnings-related volatility.

Contribution

It demonstrates that bimodality and concavity in IV smiles are common before earnings, linking these features to market risk and investor hedging strategies.

Findings

Concavity in IV smiles indicates increased market risk.

Investors pay premiums to hedge against earnings volatility.

Bimodality in risk-neutral distributions is prevalent before earnings.

Abstract

Earnings announcements (EADs) are corporate events that provide investors with fundamentally important information. The prospect of stock price rises may also contribute to EADs increased volatility. Using data on extremely short term options, we study that bimodality in the risk neutral distribution and concavity in the IV smiles are ubiquitous characteristics before an earnings announcement day. This study compares the returns between concave and non concave IV smiles to see if the concavity in the IV curve leads to any information about the risk in the market and showcases how investors hedge against extreme volatility during earnings announcements. In fact, our paper shows in the presence of concave IV smiles; investors pay a significant premium to hedge against the uncertainty caused by the forthcoming announcement.