The most dangerous options trade around earnings?

by Derek Moore on January 13th, 2014

With Netflix (NFLX) due to report earnings next Wednesday January 22nd after the close, I thought it was a good time to review the long straddle option trade. Quite often I get questions around how to trade options with earnings announcements. On the surface it would seem easy. Everyone knows earnings can be one of the biggest catalysts in large moves in price. Why not simply buy a call and a put on the same stock the day before earnings as the price is sure to move one way or another?
 
Well, everyone does know this. Especially with high beta stocks such as Netflix that as we will examine can move 25% overnight. Options prices bake in things like earnings releases. The more the market expects an underlying to move, the higher an options price. On the surface buying an at the money call and put, known as a long straddle, seems like a simple trade. But don’t mistake the simplicity with entering the order with the very complex makeup of the strategy.
 
Later we will look at two examples of a long straddle with two completely different outcomes. One would have made $14,925, the other lost $10290. Want to know why?
 
Options traders are making a bet each time on the direction and magnitude of a move. If  price moves greater than expected, traders may make money. That expectation is reflected in what is called Implied Volatility or IV. Unlike Historical Volatility which says what has happened, IV is a forward looking estimation of what will happen. Stocks, ETF’s, and Indexes have an implied volatility. Then each series whether they be weeklies or standard monthly options have their own Implied Volatility.
 
For example, as of midday NFLX weekly options expiring Friday Jan 17th have an implied volatility of 37.69%. The weekly options expiring the following friday Jan 24th have more than double that at 84.47%. Well, this weeks options do not include an earnings release. Next weeks do. Whenever you see spikes in IV, usually a good bet that their is an earnings release or some other news event. For comparison, this week’s SPX options only have a 12.90% IV.
 
So what does this mean to traders? This can be a bit technical but you should if nothing else understand that the higher implied volatility is, the more expensive options are because their is an expectation for bigger moves. Plus, you are starting to get the idea that there is much more involved in this trade!
 
 
Now, a bit of math before we examine to great examples of when the long straddle works and doesn’t work right before earnings. Let’s lay out the steps to figure out what the market is telling us. Many of you remember being graded on a bell curve. The idea that most results will fall in 1 standard deviation 68% of the time. Well the options market through prices is telling us what it thinks a move will be +/- of the underlying.
 
Here are the steps:
 
-Figure the square root of 252. The number of trading days in a year. It’s about 15.8745
-Feel free to round to 16 as many traders do to make next steps easier.
-Divide the IV/15.8745 to get the % 1 day move the options market is pricing in.
 
So we said the S&P options had an IV of 12.90.  If you divide 12.90/15.8745 you get in percentage terms .81%. So what that is saying is the options market is pricing premiums on SPX options expecting a 1 standard deviation move to be +/-  .81% over 1 day. Doing the same calculation, Netflix with an IV of 37.69% would imply an expected daily move of almost 2%.
 
Enough math for now! We need to examine the trades!
 
First example we go back to NFLX on 4/22/13. One day before earnings are released.
 
NFLX priced at $174.37
NFLX IV is 167.28% implying a one day move of 10.54%
4 days to the weekly option expiration.
 
Enter a 10 contract long straddle
 
Buy 10 Calls on April Weekly 175 strike
Buy 10 Puts on April Weekly 175 strike    Net debit of $26.875
 
Next day NFLX moves up 24.4% to $216.99 and this straddle made a profit of $14,925! So your thinking this is easy right? Well, more on that in a bit. What you had happen is the market gapped up much more than the options market predicted. Therefore in hindsight you were able to buy options that were undervalued compared to the move. So what could go wrong?
 
Next example 10/21/13
 
NFLX priced at $354.99
NFLX IV is 128.23% implying an 8.7% one day move.
4 days to the weekly option expiration
 
Enter a 10 contract long straddle
 
Buy 10 Calls on October Weekly 355 strike
Buy 10 Puts on October Weekly 355 strike   Net debit of $45.05
 
After earnings NFLX moves lower by 9.1% or 32.46 points. The straddle lost $10,290. What happened? Netflix didn’t move enough to support the prices you paid to get into the straddle. Now you might be saying, wait a minute. It moved more than expected? Yes, but keep in mind, when you purchase a straddle you are paying higher prices on both the calls and the puts. So you actually need more of a move than you would with just once side of the trade. And, typically after a news event where implied volatility was high, it collapses the next day after the cats out of the bag. In our October example, IV dropped from 138.23% down to 77.86% the very next day. What this drop in IV meant is that options prices reflected a reduced opinion about how far NFLX would move on a day to day basis. Lower expectations for the magnitude of moves mean lower premiums.
 
A few final thoughts. We used the weekly options as they provide a more extreme example of what volatility rising or failing can do to trades. There are many reasons why very short term options might not be the best choice as there is little time to adjust the trade if it goes against you. This wasn’t meant as a vote for or against using the strategy. More, I want you to understand what goes into a very complex trade with a lot of moving parts.
 
What topics would you like to see us cover? Use the comments section below to let us know. 


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