Volatility arbitrage around earnings announcements: Evidence from the Korean equity linked warrants market

Abstract

We examine the presence and performance of volatility arbitrage opportunities around earnings announcements using daily ELW (equity linked warrant) trade data in the Korean market. We find that volatilities drift in a predictable and monotonic fashion, which is different from findings in prior literature. The predictable drift generates a volatility arbitrage opportunity. Our trading strategy exploits both the pre- and the post-announcement drift of implied volatilities and generates a sizable trading profit of 11.4% per ELW contract in excess of transaction costs during the 21 business days around the earnings announcement date. In particular, short-term deep out-of-the-money ELWs deliver a 26.0% trading profit per ELW contract. The profits remain robust after considering the liquidity of ELWs and assuming very high transaction costs. Our results suggest that the Korean ELW market is not a level playing field because the trading strategy is easily implementable for liquidity providers while difficult for retail investors.