Imagine buying a ticket that allows you to bet on the roll of a six-sided die. If die rolls a number greater than 3, then the purchaser of the ticket would win 1 dollar total from the seller. What would be the fair price of this ticket?
Obviously, the fair price of the ticket would be 50 cents. We know this because our desired result has a 50% chance of happening. Therefore, a purchaser of the ticket would always bid at least 49 cents for the ticket, while a seller of the ticket would always be willing to sell the ticket for 51 cents.
But what if the event we were betting on didn't have a defined probability of occurring? This forms the crux of how we will attempt to reveal the efficiencies - and inefficiencies - during earnings events.
The market misprices tail-end risk before known volatility events such as earnings reports, as most traders anticipate large price moves in the underlying stock.
A tight vertical spread is a simple, but highly effective, option strategy that gives us insight into how the market is pricing an earnings move. From our analogy above, the vertical spread is the "ticket" that we can either sell or purchase for our strategy.
At the same time, we can calculate the probabilities of historical earnings moves via historical data. By combining these two data sets, we are able to compare what the market currently thinks to what has happened in the past.