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Kim

How NOT to trade NFLX earnings

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This video describes a trade on NFLX before earnings. The rationale was to take advantage of the increased volatility in our option by initiating this earnings play.

 

We will show you in this video why this trade had a bad risk/reward despite inflated IV.

 


 

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    • By Kim
      The reason is simple: over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses.


      Kirk Du Plessis from OptionAlpha seems to agree. 

      He conducted a backtest proving that holding a straddle through earnings is on average a losing proposition.

      Here are the highlights of his research.
       
      Key Points:
      Often times traders go through cycles where the stock makes incredibly big moves. This encourages traders to buy long straddles heading into earnings; a long call/put at the money assuming that the stock will make a big move so that you can profit from it.  However, it is not the case that the stock always consistently moves more than expected in the long term. The market is smart enough to overcorrect and implied volatility always overshoots the expected move, on average.  Case Study 1: Apple
      Did a long straddle every time earnings were present, all the way back to 2007 through now. This is a lot of earnings cycles and a lot of different information for Apple. Since then Apple has had a considerable move, which really challenges the validity of the strategies. We entered a long straddle at the money the day before earnings and took it off the next day. The stock was trading at $90; we bought the 90 put and the 90 call and closed it right after earnings were announced the next morning. 
      Results: 
      A long straddle in Apple for earnings only ended up winning 41.38% of the time.  The average return over 10 years was -1.31%. Over the long haul, a long option strategy results in a negative expected return, especially in a stock like Apple. On the opposite end of this trade, if you had done the short straddle instead of buying options, you would have generated at least 60% of the time and expected a positive return.  The straddle price before earnings, on average, was $15.  The straddle price directly after earnings went down to about $7.95; not a great choice for long-option buyers. Case Study 2: Facebook 
      Entered the same long straddle position, entering right before earnings were announced and exiting again right after earnings were announced. This strategy only won 27% of the time, which is a huge miss for Facebook percentage-wise. These long options strategy simply do not perform as well as we think over time.
      Results:
      Had an annual return of 0.70%. Only a couple of months ended up being the determining factor to keep it above board.  If you missed a couple of those really big moves or if Facebook moved much higher than expected, then it would have resulted in a much more negative return. On the counter side, if you had traded the short option strategy it would have worked out well, generating a positive expected return.  On average, the market priced these straddles at about $5.62 before earnings. After they announced earnings, the straddle pricing went down to $1.78.  The key was that the crash in the volatility and the straddle pricing is really why this strategy was a big loser.  However, this was a really good winner for option sellers.   The average expected move in Facebook was $6.45 and the actual expected move on Facebook was $7.09. Facebook out-performed on average.  If you could remove the biggest outlier from 2013, then Facebook under-performs by $6.16. More recently, Facebook has begun to consistently under-perform its expected moves. Case Study 3: Chipotle
      With Chipotle we used the same strategy as with Apple and Facebook, entering into a long straddle right before earnings and exiting it right after earnings. 
      Results:
      The overall win rate was 35.48%. The average annual return was -2.59%, losing a significant amount of money in the trade.  This again consistently led option sellers to be the beneficiaries of the earnings trade in Chipotle. The average price of the straddle heading into the earnings event was 26.26%. The stock went from the low 60's, all the way up to the 600's and back down to 400 - so the straddles are naturally going to be more pricey.  On average the straddle price was 26.26 and after earnings the straddle price was 11.21, collapsing by more than half.  There are huge moves in Chipotle, but they do not overshadow what actually happened in the long term. Expected move in Chipotle was 7.01 and the actual move was 5.28 - the market vastly underperformed.  Conclusion:
      After big moves, we start to see expected moves and the stock expands and then smaller moves follow. Generally speaking, when the stock outperforms the expectation the next couple of cycles end up being fairly quiet.  If we do find ourselves in a quiet period where the stock has performed really well, we should be careful that it could surprise us shortly.  Likewise, if the stock has been really volatile and has outperformed and moved more than expected in the last couple of cycles that means we could potentially be more aggressive as it might underperform heading forward. Generally, there is also a lag time between the market catching up - earnings trades only happen four times a year.  The market participants don't get a lot of data throughout the year to make changes to expectations and trading habits.  If the stock has a huge move after earnings, more than expected, it might take a cycle or two for the options pricing to catch up and realize the new normal.  At the end of the day, realizing how much these numbers gravitate towards what they should be on average, long-term is really powerful.  You can listen to the full podcast here.

      This research confirms what we already knew:

      It is easy to get excited after a few trades like NFLX, GMCR or AMZN that moved a lot in some cycles. However, chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.

      Thank you Kirk!

      The next question is of course: if holding a long straddle through earnings is a losing proposition, why not to take the other side and short those straddles?

      But lets leave something for the next article..

      Related articles:
      How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings Straddle Option Overview  
    • By Kim
      As a reminder, a strangle involves buying calls and puts on the same stock with different strikes. Buying calls and puts with the same strike is called a long straddle. Strangles usually provide better leverage in case the stock moves significantly.

      So let’s see how it works. First, you must identify stocks which have a history of big post-earnings moves. Some examples include AMZN, Netflix, Google, Priceline (PCLN), and others. Then you buy a strangle or a straddle a day or two before the earnings are announced. If the stock has a big move, you sell for a big profit.

      The problem is you are not the only one knowing that earnings are coming. Everyone knows that those stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.

      Let’s examine a few test cases from the 2011 earnings cycle.
      AKAM announced earnings on Oct. 26. The $24 straddle could be purchased for $4.08. IV was 84%. The next day the stock jumped 15%, yet the straddle was worth only $3.81. The reason? IV collapsed to 47%. The market “expected” the stock to move 17-18%, based on previous moves, but the stock moved “only” 15% and the straddle lost 7%. BIDU announced earnings on Oct. 26. The stock moved 4.5% following the earnings. You could purchase the straddle at $19.55 the day before earnings. The same straddle was worth $13.47 the next day. That’s a loss of 31%. TIVO moved 2%, the straddle lost 29%. FSLR moved 3%, the straddle lost 55%. Now let’s check a couple of good trades.
      NFLX announced earnings on October 24. The stock collapsed 34.9% the next day, a move of historical proportions. The 120 strangle could be purchased the day before earnings at $24.52 and sold the next day at $43.00. That’s a 75% gain, but this is as good as it gets. This is a move of historic proportions but the trade is even not a double. AMZN straddle gained 57%. CME straddle gained 62%. GMCR straddle gained 84%. It is easy to get excited after a few trades like NFLX, GMCR, CME and AMZN. However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double what was expected. NFLX and GMCR moved more than 35%, the largest moves in at least 10 years. Chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.
       
      Some people might argue that if the trade is not profitable the same day, you can continue holding or selling only the winning side till the stock moves in the right direction. It can work under certain conditions. For example, if you followed the specific stock in the last few cycles and noticed some patterns, such as the stock continuously moving in the same direction for a few days after beating the estimates. Another example is holding the calls when the general market is in uptrend (or downtrend for the puts). However, it has nothing to do with the original strategy. From the minute you decide to hold that trade, you are no longer using the original strategy. If the stock didn’t move enough to generate a profit, you must be ready to make a judgement call by selling one side and taking a directional bet. This might work for some people, but the pure performance of the strategy can be measured only by looking at a one day change of the strangle or the straddle (buying a day before earnings, selling the next day).
       
      The bottom line:

      Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
       
      Jeff Augen, a successful options trader and author of six books, agrees:
      It doesn’t necessarily mean that the strategy cannot work and produce great results. However, in most cases, you should be prepared to hold beyond the earnings day, in which case the performance will be impacted by many other factors, such as your trading skills, general market conditions etc.

      This article was originally published here.

      Related articles:
      How We Trade Straddle Option Strategy Exploiting Earnings Associated Rising Volatility Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Straddle, Strangle Or Reverse Iron Condor (RIC)? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How To Calculate ROI On Credit Spreads Straddle Option Overview Long Straddle Through Earnings Backtest Straddles - Risks Determine When They Are Best Used The Gut Strangle Long And Short Straddles: Opposite Structures  
       
    • By ORATS_Matt
      For this reason, front month expirations will generally have higher IVs than back months. After earnings, the implied volatility falls more in the front months than in the back months for this reason.  
       
      There are various measurements to view this effect. Measuring the effect starts with estimating where IV will fall in each of the expirations. This can be accomplished by estimating an earnings effect in each month and varying the effect until the relationship between the IVs make a rational term structure. A rational term structure is where the expirations fit into a smooth curve drawn over time. The term structure is not necessarily a flat as many calculations use. Sometimes the term structure will solve to contango, with aa lower front month, or in backwardation with higher front IVs than back month IVs. 
       
      When the part of IV that is the earnings effect is extracted from the raw IV, an ex-earnings IV can be compared. Below is a list of stocks with IV 30 day divided by ex-earnings IV 30 day sorted from highest to lowest.
       
      UPS is the highest ratio at 1.31 with the IV=49.48% and ex earnings IV=37.78%.



       
      Here's a view of the monthly unadjusted ATM IV for UPS. May 27th is about 30 days out and the IV is 48%. Constructing a rational term structure taking out an earnings effect over the months makes a 38% ex earnings IV for May 27th. The front month of 4/29/22 trading at 106% IV is expected to come down to 47%. The term structure, post earnings is still in backwardwardation. 



       
      An options trade to take advantage of this high IV vs ex earnings IV is a time spread or calendar spread. 



       
      The May-20 June-17 $185 Long Call Calendar has the following profile:



       
      The break even points are estimated at $168.38 -9% and $205 +11%.
      The history of UPS moves versus expectations are below:



       
      There are two moves of +14% in the last 12 observations but the rest of the earnings moves would probably result in a winning trade.

      About the Author: Matt Amberson, Principal and Founder of Option Research & Technology Services. ORATS was born out of a need by traders to get access to more accurate and realistic option research. Matt started ORATS to support his options market making firm where he would hire statistically minded individuals, put them on the floor, and develop research to aid in trading options. He is heavily involved with product design and quantitative research. ORATS offers data and backtesting on a subscription basis at www.orats.com. Matt has a Master’s degree from Kellogg School of Business.
       
      Related articles:
      How We Trade Calendar Spreads Understanding Implied Volatility Few Facts About Implied Volatility What is Volatility Skew
    • By Kim
      About six months ago, I came across an excellent book by Jeff Augen, “The Volatility Edge in Options Trading”. One of the strategies described in the book is called “Exploiting Earnings - Associated Rising Volatility”. Here is how it works:
      Find a stock with a history of big post-earnings moves. Buy a strangle for this stock about 7-14 days before earnings. Sell just before the earnings are announced. For those not familiar with the strangle strategy, it involves buying calls and puts on the same stock with different strikes. If you want the trade to be neutral and not directional, you structure the trade in a way that calls and puts are the same distance from the underlying price. For example, with Amazon (NASDAQ:AMZN) trading at $190, you could buy $200 calls and $180 puts.

      IV (Implied Volatility) usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes.

      Like every strategy, the devil is in details. The following questions need to be answered:
      Which stocks should be used? I tend to trade stocks with post-earnings moves of at least 5-7% in the last four earnings cycles; the larger the move the better. When to buy? IV starts to rise as early as three weeks before earnings for some stocks and just a few days before earnings for others. Buy too early and negative theta will kill the trade. Buy too late and you might miss the big portion of the IV increase. I found that 5-7 days usually works the best. Which strikes to buy? If you go far OTM (Out of The Money), you get big gains if the stock moves before earnings. But if the stock doesn’t move, closer to the money strikes might be a better choice. Since I don’t know in advance if the stock will move, I found deltas in the 20-30 range to be a good compromise. The selection of the stocks is very important to the success of the strategy. The following simple steps will help with the selection:
      Click here. Filter stocks with movement greater than 5% in the last 3 earnings. For each stock in the list, check if the options are liquid enough. Using those simple steps, I compiled a list of almost 100 stocks which fit the criteria. Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Netflix (NASDAQ:NFLX), F5 Networks (NASDAQ:FFIV), Priceline (PCLN), Amazon (AMZN), First Solar (NASDAQ:FSLR), Green Mountain Coffee Roasters (NASDAQ:GMCR), Akamai Technologies (NASDAQ:AKAM), Intuitive Surgical (NASDAQ:ISRG), Saleforce (NYSE:CRM), Wynn Resorts (NASDAQ:WYNN), Baidu (NASDAQ:BIDU) are among the best candidates for this strategy. Those stocks usually experience the largest pre-earnings IV spikes.

      So I started using this strategy in July. The results so far are promising. Average gains have been around 10-12% per trade, with an average holding period of 5-7 days. That might not sound like much, but consider this: you can make about 20 such trades per month. If you allocate just 5% per trade, you earn 20*10%*0.05=10% return per month on the whole account while risking only 25-30% (5-6 trades open at any given time). Does it look better now?

      Under normal conditions, a strangle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV. In some cases, the theta is larger than the IV increase and the trade is a loser. However, the losses in most cases are relatively small. Typical loss is around 10-15%, in some rare cases it might reach 25-30%. But the winners far outpace the losers and the strategy is overall profitable.

      Market environment also plays a role in the strategy performance. The strategy performs the best in a volatile environment when stocks move a lot. If none of the stocks move, most of the trades would be around breakeven or small losers. Fortunately, over time, stocks do move. In fact, big chunk of the gains come from stock movement and not IV increases. The IV increase just helps the trade not to lose in case the stock doesn’t move.

      In the next article I will explain why, in my opinion, it usually doesn’t pay to hold through earnings.

      The original article was published here.
       
    • By Kim
      So if options are on average overpriced before earnings, why not to sell those options and hold the trade through earnings?
       
      There are few ways to sell options before earnings to take advantage of IV crash.
       
      One if through an Iron Condor. Many options sites do this strategy on a regular basis, based on high IV rank alone. I described here why selling options based on high IV rank alone might be not a smart move. The article described selling iron Condor on NFLX, based on the very high IV rank of NFLX options before earnings.
       
      Unfortunately, NFLX is one of the worst stocks to trade this strategy. While options on average tend to be overpriced before earnings, NFLX is one of the exceptions. In fact, it moves on average more after earnings than the options imply. So there is no statistical edge to sell NFLX options. The opposite is true - there might be a statistical edge to actually buy them and hold through earnings.
       
      Another strategy to take advantage of elevated IV is through a calendar spread, where you sell the near term options and buy longer term options.
       
      So when you buy options before earnings (via straddle or strangle) you want the stock to move. If it does, the gamma gains will outpace the IV collapse.
       
      When you sell options before earnings (through calendar or Iron Condor), you want the stock to stay relatively close to the current price.
       
      In the straddle article, I described a TWTR trade from one of the options "gurus" that has lost 55%. The same guru recommended the following calendar spread before TXN earnings:
       
      Sell -25 TXN OctWk4 53 Call
      Buy 25 TXN Nov15 53 Call
       
      The rationale of the trade:
       
      Over the years, (TXN) has been one of my favorite earnings plays to trade. A very consistent winner, I have almost exclusively used a Neutral Calendar Spread on it, which is a strategy that takes advantage of over-priced options (high Implied Volatility) and time-decay. This strategy works best with stocks that have weekly options, and (TXN) has these available.
      Historically, (TXN) is just not a very volatile stock. Every rare so often, even when the stock has moved more than expected, the Neutral Calendar Spreads hold up extremely well.
       
      Last quarter, the stock had the following price movement after reporting earnings:
      Jul 23, 2015 49.84 51.26 49.59 50.51 13,271,800 50.17
      Jul 22, 2015 48.30 49.64 48.00 49.30 15,381,500 48.97
      This trade is priced great, so recommend getting in as soon as possible. 10/10.
       
      Fast forward to the next day after earnings: TXN gaped up 10%, and the calendar spread has lost 90%+. So much for "the Neutral Calendar Spreads hold up extremely well."

      The rational behind holding calendars through earnings is that IV of the short options will collapse much more than the IV of the long options, so the short options will lose much more than the long options and the spread will make money. While this is true, the calendar will make money from IV collapse only if the stock doesn't move much after earnings. The rule of thumb is: look at the "expected move" as measured by ATM straddle value before earnings. If the stock moves less than the expected move after earnings, the calendar will make money. If it moves more, the calendar will lose money. And if it move much more than expected, the calendar will lose a lot, because the time value of both options will be close to zero.
       
      And here lies the problem: even if you have a long term edge (buy straddle on stocks that move more than expected and buy calendar on stocks that move less than expected), from time to time those stocks will not behave "as expected, based on historical data", and the trades will be big losers. When this happens, there is nothing you can do to control the risk and minimize the loss.
       
      That said, it doesn't mean you cannot use one of those strategies and hold through earnings, assuming you use the right strategy for the right stocks. But you need to assume a 100% loss right front, be fully aware of the risk and use the correct position sizing. Those options "gurus" who fail to even mention the risks don't do their job properly.
       
      We invite you to join us and learn how we trade our options strategies in a less risky way.
       
      Start Your Free Trial
    • By Mark Wolfinger
      I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.
       
      Mark's response:
       
      1) To me they are the same, with the straddle being a subset of the strangle  In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.
       
      I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike.  I prefer to sell OTM calls and puts – and that's not possible with a straddle.
       
      As far as unlimited risk is concerned, that's a decision for each trader.  I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.
       
      2) A clarification.  In is not 'volatility' that incurs a large decrease after the news is released.  Instead it is the implied volatility of the options.  I'm fairly certain that is what you meant to say.
       
      3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.
       
      4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news."  The market has made an estimate of how much the stock price is likely to move.  Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.
       
      There is no formal prediction of move size.  There is nothing that says the stock will move 6.35 points.  What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options.  And it makes no difference if they are calls or puts.  At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. 
       
      From the IV, the 'anticipated move' for the underlying is determined.  AsI said, it's not as is everyone agreed on how much the stock will move.
       
      I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move.  Many times the move is far less than expected.  That's the reason why selling options prior to earnings can be very profitable.  The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.
       
      However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV decrease doesn't do a whole lot of good.  Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.
       
      Also remember that part of the time that stock price gaps by far more than expected.  In that scenario, a higher quantity of formerly OTM options are now ITM.  Thus, large losses are not only possible, but they are more frequent that you realize.  Apparently your trades have worked out well (so far).
       
      Think about this:  If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago.  The truth is that these option buyers collect often enough to keep them coming back for more. 
       
      5) That means you must be selective in which options you sell into earnings news.  This is especially true when you elect to sell naked options.  You cannot options on every stock, hoping that any random play will work.  This is a high risk/high reward game.  It's okay to participate, but please be aware of what you are doing and the risk involved.
    • By Kim
      In this article, I will show why it might be not a good idea to keep those options straddles through earnings.
       
      As a reminder, a straddle involves buying calls and puts on the same stock with same strikes and expiration. Buying calls and puts with the different strikes is called a strangle. Strangles usually provide better leverage in case the stock moves significantly.
       
      Under normal conditions, a straddle/strangle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV.
       
      The problem is you are not the only one knowing that earnings are coming. Everyone knows that some stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
       

       
      Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses.
       
      Here is a real trade that one of the options "gurus" recommended to his followers before TWTR earnings:
       
      Buy 10 TWTR Nov15 34 Call
      Buy 10 TWTR Nov15 28 Put
       
      The rationale of the trade:
       
      Last quarter, the stock had the following price movement after reporting earnings:

      Jul 29, 2015 32.59 33.24 31.06 31.24 92,475,800 31.24
      Jul 28, 2015 34.70 36.67 34.14 36.54 42,042,100 36.54

      I am expecting a similar price move this quarter, if not more. With the new CEO for TWTR having the first earnings report, the conference call and comments will most likely move the stock more than the actual numbers. I will be suing a Strangle strategy. 9/10.
       
      Fast forward to the next day after earnings:
       

       
      As you can see, the stock moved only 1.5%, the IV collapsed 20%+, and the trade was down 55%.
       
      Of course there are always exceptions. Stocks like NFLX, AMZN, GOOG tend on average to move more than the options imply before earnings. But it doesn't happen every cycle. Last cycle for example NFLX options implied 13% move while the stock moved "only" 8%. A straddle held through earnings would lose 32%. A strangle would lose even more.
       
      It is easy to get excited after a few trades like NFLX, GMCR or AMZN that moved a lot in some cycles. However, chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.
       
      Jeff Augen, a successful options trader and author of six books, agrees:
       
      “There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common – pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.”
       
      Related Articles:
      How We Trade Straddle Option Strategy Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Long Straddle: A Guaranteed Win?  
      We invite you to join us and learn how we trade our options strategies in a less risky way.
       
      Start Your Free Trial
    • By Ophir Gottlieb
      The news was three-fold fold: 

      (1) The Board of Directors has named Nikesh Arora as its new chief executive officer and chairman of the Board of Directors, effective June 6, 2018. He succeeds Mark McLaughlin, who is transitioning to the role of vice chairman of the Board for Palo Alto Networks. 

      Nikesh Arora was the president and chief operating officer at SoftBank, but he is most famously known as the chief business officer at Google where he took the search business from $2 billion in revenues to over $60 billion in revenues. 

      (2) The company pre-announced that in the fiscal third quarter, total revenue grew 31% percent year over year to $567.1 million, product revenue grew 31 percent year over year to $215.2 million, and billings grew 33 percent year over year to $721.0 million. 

      This $567.1 million number is a whopping earnings beat, where analyst expectations were $545.68 million and in a range of [$540 million, $556.4 million]. The CFO went on to say that "[w]e had a strong fiscal third quarter 2018 and will be reporting top line and bottom line results above all our third quarter guided ranges." 

      (3) Palo Alto Networks will host a conference call for analysts and investors to discuss its fiscal third quarter 2018 results and outlook for its fiscal fourth quarter and full fiscal year 2018 on Monday, June 4th before the market opens. 

      It's that last little bit that changed everything for option traders. PANW burying its news in a late Friday press release leaves the option holders with a coin flip -- not a well measured probability bet. 

      PREFACE 
      On 4-27-2018, we published the dossier Applying The New Standard of Repeating Momentum in Palo Alto Networks Inc. 

      In that dossier we noted that "We have empirically and explicitly demonstrated the repeating pattern of bullish momentum right before earnings. [Further we find] in Palo Alto Networks Inc (NYSE:PANW) exactly the two-tiered pattern we researched again -- stocks that have pre-earnings momentum, and ones with a recent history of large beats that push this momentum into the next quarter." 

      These were the results over the last one-year in Palo Alto Networks of owning a 40 delta (out of the money) call 6-days pre-earnings and selling the call before the earnings announcement. Since PANW reports after the market closes, this test looks at holding the call right until the end of that trading day, and then selling before the announcement. 
       
      PANW: Long 40 Delta Call   % Wins: 100%   Wins: 4   Losses: 0   % Return:  175% 
      Tap Here to See the Back-test
      But all of those results were predicated on avoiding the earnings release and we noted that the back-tested looked at a trade that closes before earnings, so this trade does not make a bet on the earnings result. 

      With the extremely odd news, released at an extremely odd time, this is no longer the case. Earnings be released before the market opens, and will not give option traders the ability to exit any option positions before the earnings event occurs. 

      WHAT HAPPENED 
      In over two decades of option trading and as an option market maker on the exchange floors, I cannot recall a single time when a company announced a new CEO, an earnings beat (but with partial numbers), and then announced earnings on the same day as planned but moved the time from after the market to before the market all at once. 

      Usually when companies pre-release, it's very early -- like Micron did about 6-weeks before earnings in the last couple of weeks. 

      This is simply a case of terrible luck. Now, for anyone with an option position in PANW that intended to avoid the risk of the actual earnings news, we are left with exactly the opposite. Any position now has become a straight down the middle earnings bet - the kind most traders try to avoid at all costs. 

      But, this is it, there is no changing it now. For those that are long calls in the weekly options, the only hope to turn a profit on that position now is for a large earnings move up for the stock. The hope is that the pre-announcement will be backed by even better EPS and guidance news and that the introduction of a Silicon Valley super star as CEO drives the stock higher. 

      But, make no mistake, PANW burying its news in a late Friday press release leaves the option holders with a coin flip -- not a well measured probability bet. 

      Tap Here to See the Tools at Work 

      Risk Disclosure 
      You should read the Characteristics and Risks of Standardized Options. 

      Past performance is not an indication of future results. 

      Ophir Gottlieb is the CEO & Co-founder of Capital Market Laboratories. Mr Gottlieb’s learning background stems from his graduate work in mathematics and measure theory at Stanford University and his time as an option market maker on the NYSE and CBOE exchange floors. He has been cited by Yahoo! Finance, CNNMoney, MarketWatch, Business Insider, Reuters, Bloomberg, Wall St. Journal, Dow Jones Newswire, Barron’s, Forbes, SF Chronicle, Chicago Tribune and Miami Herald and is often seen on financial television. He created and authored what was believed to be the most heavily followed option trading blog in the world for three-years.This article is used here with permission and originally appeared here.
    • By Kim
      tastytrade tried to Put The Nail In The Coffin On Buying Premium Prior To Earnings. They did it several times, and we debunked their studies several times. 

      Kirk Du Plessis from OptionAlpha conducted a comprehensive study backtesting different earnings strategies. This is the part that is relevant to our pre earnings straddle strategy:

       

      The conclusion is that buying long straddle (or strangle) and closing the day before earnings is a losing proposition. The backtest included different entry days from earnings: 30, 20, 10, 5, or 1 day from the earnings event.

      Our real life trading results are very different:



      You can see full statistics here.

      The question many people ask us: are all those studies wrong? How their results are so different from our real life trading performance?

      The answer is that the studies are not necessarily wrong. They just have serous limitations, such as:
      The studies use the whole universe of stocks, while we use only a handful of carefully selected stocks that show good results in backtesting.
        The studies use certain randomly selected entry dates, while we enter only when appropriate.
        The studies use EOD (End Of Day) prices while we take advantage of intraday price fluctuations.
        The studies exit a day before earnings while we manage the trades actively by taking profits when our profit targets are hit.   This makes a world of difference.

      If you are not a member yet, you can join our forum discussions for answers to all your options questions.
       
      Here is a classic example how real trading is different from "studies".

      On March 2 2:30pm we entered CPB straddle:



      The price was 3.05 or 6.5% RV. When considering a trade, we look at the straddle price as percentage of the stock price. We call it RV (Relative Value). We based our entry on the CPB RV chart:



      We exited the trade on March 3 10:05am for $3.45 credit, 13.1% gain



      EOD price on March 2 was 3.40 and EOD price on March 3 was 2.95. The study using EOD prices would show 13.2% LOSS while our real trade was closed for 13.1% GAIN.

      Two points that contributed to the difference:
      We have a very strict criteria for entering those trades. In some cases we might wait weeks for the price to come down and meet our criteria. Based on historical RV charts, we would not even be entering this trade at 3.40.
        On the last day, we did not wait till the EOD and closed the trade in the morning when it reached our profit target. This is just one example how a "study" can show dramatically different results from real trading.

      On a related note, using a dollar P/L in a study is meaningless - this alone disqualifies the whole study. The only thing that matter is percentage amount. Why? Because in order to get objective results, you need to apply the same dollar allocation to all trades.

      For example, lets take a look on stocks like AMZN and GM. AMZN straddle can cost around $200 and GM straddle around $2. If AMZN straddle average return was -10% or -$20 and GM average return was +50% or $1, the average return should be reported as +20%. In the study, it would be reported as -$9.5.

      Don't believe everything you read. Use your common sense and take everything with a grain of salt. 

      I have a great respect for Kirk. He is one of the most honest, professional and hardworking people in our industry, but even the greatest minds sometimes get it wrong.

      Related articles:
      How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings
    • By Kim
      Trade Explanation: For the Volatility Advisory in NFLX, we are selling the Apr 427.5 puts and 520 calls and buy the Apr 425 puts and 522.5 calls for a net credit of $0.91 to open.
       
      Underlying Price: $474.22
       
      Price Action: We are selling this $2.5-wide Iron Condor in the online streaming company for a credit of $0.91. For an Iron Condor trade, we sell an out-of-the-money Call Vertical (520/522.5) and Put Vertical (427.5/425) simultaneously. The company has earnings after the close and the option markets are pricing in a move of 8-9%. We expect the shares to move after the report but are giving ourselves a nice range of $92.5 between the short strikes. We need the shares to continue to trade between our break-even levels of $426.59 on the downside and $520.91 on the upside.
       
      The following was described as a rationale for the trade:
       
      Volatility: Volatility is elevated in the Apr options which makes this trade attractive. The IV percentile rank is elevated at 73% also which also gives us a good opportunity to sell this Iron Condor. We expect volatility to fall sharply after earnings which will contract the value of this short-term neutral position.
       
      Probability: There is an 80% probability that NFLX shares will be below the $520 level and a 80% probability that it will be above the $427.5 level at Apr expiration. This trade offers a good Risk/Reward scenario with the amount of credit collected vs. the probability numbers for this position.
       
      Trade Duration: We have 2 days to Apr expiration in this position. This is a short-term position and time decay will increase quickly due to the time frame and the earnings report.
       
      Logic: We want to take advantage of the increased volatility in our option by initiating this earnings play. Our short verticals are outside of the anticipated one standard deviation move that the options are pricing in so our probabilities are positive. The shares will hopefully remain between our short verticals and we will be aggressive in closing the trade.
       
      My comments:
      It is true that Volatility is elevated in the Apr options, but this is completely normal, considering the upcoming earnings and does NOT make the trade attractive.
        It is also true that volatility will fall sharply after earnings, but it is not relevant if the stock will be trading above the long strikes. In this case, the trade will still lose 100%.
        2 days to Apr expiration makes the trade much more risky because there will be no time to adjust or take any corrective action.
        "80% probability that NFLX shares will be below the $520 level" means nothing when earnings are involved. The price action will be determined by earnings only, not by options probabilities.
        "The shares will hopefully remain between our short verticals" - hope is not a strategy.
        The short strikes are less than 10% from the stock price, which is not far enough, considering NFLX earnings history.
      Now, I want you to take a look at the last 10 cycles of NFLX post-earnings moves:
       

      (This screenshot is taken from OptionSlam.com).
       
      Now, I'm asking you this:
       
      WHO IN HIS RIGHT MIND WOULD TRADE AN IRON CONDOR WITH SHORT STRIKES LESS THAN 10% FROM THE STOCK, ON A STOCK THAT HAS TENDENCY TO MOVE 15-25% AFTER EARNINGS ON A REGULAR BASIS???
       
      The stock is trading above $530 after hours. If it stays this way tomorrow, this trade will be a 100% loser, and there is NOTHING you can do about it. But frankly, the final result doesn't really matter. To me, this trade is simply insane and shows complete lack of basic options understanding.
       
      That said, I'm not completely dismissing trading Iron Condors through earnings. For many stocks, options consistently overestimate the expected move, and for those stocks, this strategy might have an edge (assuming proper position sizing). But NFLX is one of the worst stocks to use for this strategy, considering its earnings history.
       
      Watch the video:
       
       
      If you want to learn how to trade earnings the right way (we just booked 30% gain in NFLX pre-earnings trade):
       
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