I thought I would let you see the mental exercise that I do when deciding on an earnings trade. The big stock with earnings to be released this evening is Netflix (NFLX).
First off, let me say that I hate the Netflix service. I thought I’d be an ideal candidate for the service--I’m somewhat tech savvy and I like movies--yet I found maybe two movies of interest during my Netflix free trials.
But I don’t let my thoughts on a company cloud my thinking when I’m seeking an options trade. I’m not sure if this is a momentum stock or the growth of the next great company, but I can’t fight the stock’s chart.
The first thing I do when I examine an earnings stock is examine the at the money straddle that expires this week. Right now, the October 345 straddle is trading for $41. So the buyer of this straddle needs the stock to move $41 or approximately 12% by this Friday. To me this sounds like a gigantic number and my first thought is I would be a seller of options as I am willing to “bet” that the stock will move less than that amount.
But I want to dig a bit deeper. So I go back and look at NFLX’s reaction to earnings over its last eight reports. Following its last eight reports, NFLX moved an average of 22%, which would lead me to believe that the options are actually potentially underpriced by approximately 10%.
Another factor leading me to believe that the options are potentially cheap is the market’s reaction to Google and Chipotle Mexican Grille. For example, the Google straddle was priced around $35 for its earnings and the stock moved $123. So for every 1 straddle purchased, the buyer made $8,800 per straddle.
Here is my dilemma. Options in general are grossly overpriced for earnings and historically selling options for earnings has been a massive winner. Also, it’s not cheap to buy the NFLX straddle as the purchase of one straddle for $41 is a capital outlay of $4,100, which could be lost in five days.
Having done this mental exercise, I’m going to pass on trading this earnings event. It feels like too much of a gamble to me, and I don’t gamble—I look for a trading edge.
My gut tells me that because the options are so underpriced in relation to previous earnings, the move will be somewhat muted, and I would theoretically be a seller of options. However, I don’t have a strong enough conviction at this time to put on a trade.
So what would you do? Would you buy or sell this straddle? Do you think the stock will move $41? This is a great mental exercise to do with yourself and to track its results.
Netflix Earnings Follow UpOctober 22, 2013
Thought I would update you on the hypothetical NFLX straddle. The straddle we talked about yesterday was the 345 straddle for $41—so the stock had to move more than $41 away from 345 in either direction to make money.
This morning in premarket action, I saw NFLX trade as high as 395. Unfortunately, you can’t sell a straddle before the market opens.
During the normal trading hours, the stock traded as high as 389.16 and as low as 321.50.
Theoretically, a buyer of the straddle could have gotten out for approximately a $3.16 profit at the very top—assuming he/she timed it perfectly.
Now with the stock trading at 327, the straddle is worth $23 or a loss of $18 a straddle, and it’s losing value fast.
This is why I am typically a seller of spreads for earnings trades. The volatility gets so overpriced that buying options is a losing proposition more often than not.
That being said, there are times when volatility is priced fairly and buying options for earnings offers good risk/reward—this just wasn’t one of those times.