A Volatility View of Netflix Earnings

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.