Don’t Trade Earnings Before You Read This

As you may or may not know, earnings season kicked off on April 8, 2014 with Alcoa. Many investors and short term traders love earnings season because the increased volatility…and for them, volatility creates opportunities.

You see, before an earnings announcement, option volatility (aka implied volatility) gets jacked up.

Now, if you read The Ugly Truth About Buying Options, you’ll recall that the higher the option volatility…the more expensive the option becomes.

For many companies, an earnings release causes the stock price to experience above average volatility. Think about it, new information about the performance and future guidance of the stock is about to hit the market.

Whether it’s good or bad news, it has the potential to shift the opinion of traders and investors. A long term bullish (or bearish) bias can be strengthened or weakened.

Of course, prior to the announcement, option volatility increases due to the uncertainty of this binary event (the potential that the stock will have an above average price move higher or lower).

In addition, the demand for option premium (mainly from hedgers protecting long term positions and some speculators betting on the future direction of the stock) causes option volatility to spike further.

Once the news is out and the information is absorbed, the option volatility gets sucked out of those options (in the form of premium) like a vacuum.

Some short term option investors love earnings because they feel the likelihood of options getting mispriced is increased dramatically.

Yet, others feel that trading before an event is a crap shoot…and for that reason they stay away. But for now, we’ll save that debate for another discussion.

What I really want to talk to you about today is the implied move. Have you ever watched someone on Bloomberg or CNBC talk about a stock ahead of its earnings?

Saying something along the lines: “The option market is implying the stock will have an 8% move.” What does this mean and where did they come up with that number?

The implied move is simply what the stock price would need to move (based in % terms) in order for you to break-even if you bought (or sold) an At-The-Money straddle. That’s it…nothing more…nothing less.

It is not a magic or mystical number; the stock could either overshoot or undershoot the move. The implied move gives us an indication of what kind of impact to expect from this binary event.

Now, let’s look at an example for further clarification.

On April 21, 2014, NETFLIX (NFLX) will release their earning results. At the time of this writing, NFLX is trading at $345.74 per share (4/17/14).

Now, in order to get the most accurate implied move for the event, we must select the nearest term options. Again, this is not a strategy recommendation; we are simply trying to figure out what the option market is implying for earnings.

With that said, the nearest term contracts are the April 25, 2014 options.

Because the stock is trading at $345.74 and there are no $345.74 option strikes, we’ll have to select something close to that.

Further, we’ll select the $345 calls and puts. Why calls and puts? Well, if there is a 50/50 chance the stock price will go up or down, we want to select both options to be “delta-neutral” (not having a directional bias).

After all, we are trying to figure out what the implied move is (+/-).

The math:

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The $345 call and the $345 put (straddle) have a mid-price of $39.48. The stock price is $345.74

$345 call mid-price is $20.20          5 days to expiration

$345 put mid-price is $19.28           5 days to expiration

Side note: Implied moves use the mid-price…however, in the real-world, you are not always able to get filled at the mid-price.

Break-even points:

$345 minus $39.48= $305.52       downside break-even

$345 plus $39.48= $384.48         upside break-even

Again, the stock is not trading $345, so we have to do a little bit more math.

$345.74 minus $305.52 = $40.22

$40.22 divided by $345.74 = 11.6% how low the stock needs to move for the straddle to break-even

$384.48 minus $345.74 = $38.74

$38.74 divided by $345.74 = 11.2% how much the stock needs to move for the straddle to break-even

In reality, the implied move has two break-even points. However, to make things simpler we take the two break-even points and average them to get one number.

11.6% + 11.2% = 22.8%

22.8 divided by 2 = 11.4% we took the average of the two break-even points.

This entire math could be done quickly with a calculator.

In addition, if you use the thinkorswim platform like me, there’s a feature called the “Market Maker Move” which gives you a fairly accurate implied move number. They simply take the ATM straddle and multiply it by 1.25.

For those interested, I’ll post a video on how I use it in the comments section.

Now, if you don’t use thinkorswim, many option trading platforms have graphical PnL analyzers…that display the implied move.

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Now, based on our closing prices from 4/17/14, the implied earnings move for NFLX is +/-11.4%. Will it move that much? Is the straddle cheap or expensive? Again, further analysis would need to be conducted to draw an opinion.

Also, keep in mind that this implied move includes expiration, not just the event. With that said, it’s not completely accurate to say that the implied move for earnings is 11.4%…even though the guys on TV do it all the time.

And there you have it, hopefully you have a clearer understanding of what the implied move is and how that figure is derived. In the future, if you’d like I can write more posts on how this information can be used for trading or investment purposes.

In fact, from my experience, I’ve found that the implied move is often over-priced. With that said, it creates for some incredible risk-reward opportunities using structured option positions.

I like structured option positions over buying outright calls (or puts) because of the inevitable volatility “crush.”

Again, I’ll save that discussion for a later date… for now, I just wanted to lay the ground work. As always, I’d love to hear your thoughts in the comments section below.

(Update: Netflix announced their earnings after the close on 4/22/14. The following day, the stock price closed up $24.41 to $372.96. As of the close of 4/23/14, the price of the $345 straddle is $28.75. Now, that’s what we call a “vol crush”)

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