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

ArXiv ID: 2307.15718 “View on arXiv”

Authors: Unknown

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.

Keywords: Earnings Announcements, Risk-Neutral Distribution, Implied Volatility Smiles, Bimodality, Volatility Hedging, Equities

Complexity vs Empirical Score

• Math Complexity: 6.5/10
• Empirical Rigor: 7.0/10
• Quadrant: Holy Grail
• Why: The paper employs advanced mathematical techniques like parametric curve fitting and risk-neutral distribution derivation via Breeden-Litzenberger, while the empirical section details a specific dataset from Bloomberg, uses curve fitting with defined parameters, and presents findings on implied volatility smiles and bimodality.

  flowchart TD
    A["Research Goal: Does concavity in IV smiles reveal<br>information about pre-EAD risk & hedging?"] --> B{"Key Methodology"}
    B --> C["Data: Extremely short-term options<br>on S&P 500 constituents pre-EAD"]
    C --> D["Computational Process:<br>Estimate Risk-Neutral Distribution<br>Quantify IV Smile Concavity"]
    D --> E["Analysis: Compare returns of<br>Concave vs. Non-Concave IV smiles"]
    E --> F["Key Finding 1: Bimodal RNDs &<br>concave IV smiles are ubiquitous pre-EAD"]
    E --> G["Key Finding 2: Concave IV smiles<br>signal investors pay significant premiums<br>to hedge extreme announcement volatility"]