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Pricing an earnings move · Part 3 of 3
A stock at $100 reports earnings in the next 21 trading days. The at-the-money implied volatility for that expiry is 40%, and on ordinary days the stock realises 30%. Use 252 trading days a year and zero rates.
You sell the straddle the day before earnings and delta-hedge it. The stock moves 4% on the day, and the remaining implied volatility drops back to 30%. What happens to the position?
- AIt makes money: the move was well inside the priced 7.9% and implied volatility fell
- BIt loses money, because any move of 4% in a day is a large move for a stock realising 30%
- CIt breaks even, as the delta hedge neutralises every source of P&L
- DIt loses, since short straddles always lose when volatility is realised
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