10. Implied Volatility
Implied volatility, derived from observed option prices, is arguably the single-most-important variable in option pricing. Both the level and the change of implied volatility are important to option trading around earnings announcements. The level of implied volatility determines the cost of the option, and the change in implied volatility is a major determinant in the change in the option price.
This chapter addresses three issues related to implied volatility. First, we examine the relationships between implied volatility before earnings announcements and the magnitude of earnings announcement returns. If the market is reasonably efficient, we expect to observe that higher implied volatility before earnings announcements ...
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