by Tyler Craig | October 25, 2011 12:42 pm
Earnings announcements tend to leave an indelible impression on an implied volatility chart. The anticipation of these important quarterly events leads to an all-but-guaranteed rise in volatility. But what happens afterward?
The resolution of the announcement leads to a swift drop in volatility. Earnings, then, are the underlying catalyst behind the cyclical fall and rise in stocks’ – and, therefore, options’ — implied volatility.
When structuring an options play around earnings, you must first take into consideration this pre-earnings volatility ramp-up and subsequent post-earnings volatility beat-down.
Heading into earnings, option sellers seek to exploit the “volatility crush” (i.e., when implied volatility spikes due to uncertainty about future price moves but then quickly retreats), while option buyers look to fight against it. In the end, the success of either party comes down to how well the options priced in the earnings gap.
The market is usually quite efficient and, the majority of the time, options actually overprice the earnings gap. Selling volatility in front of earnings can yield a profit more times than not. It is for this reason that many experienced options traders lean toward selling options into earnings versus buying.
Trouble arises, however, when the occasional outlier event takes place where a stock gaps considerably more than expected. Such an outcome represents the true risk of perpetually selling options into earnings. At some point, you have to pay the piper.
Consider the formerly loved, yet currently scorned Netflix (NASDAQ:NFLX) for example. Heading into last night’s earnings, NFLX was trading around $119.
A pre-earnings options trading strategy that many traders use is called the use the “straddle.” That’s when they buy both the at-the-money call option and the at-the-money put. The idea behind this strategy is to use it when you don’t know whether the stock will go up or down, and your goal is to make more on the “winning” option than you lose on the “losing” one.
In the case of Netflix, the weekly October 120 straddle was pricing in about an $18.40 (or 15%) move in either direction.
While volatility was elevated heading into earnings, it wasn’t high enough – not even close. Today’s monster gap lower to $76 resulted in the October 120 straddle surging in value to $42.80 — a 232% increase! This go-around, put option buyers were handsomely rewarded while those seeking to profit from the volatility crush were punished.
At the time of this writing, Tyler Craig had no positions in Netflix.
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