1) The document explains how to calculate the implied move for a stock's price based on its option prices ahead of an earnings announcement. 2) Using Netflix as an example, the author calculates the implied move for NFLX ahead of its April 2014 earnings to be +/- 11.4% based on the prices of at-the-money straddle options. 3) The implied move represents the approximate range the stock price would need to change for the straddle position to break even, though the real change could be more or less.

1. Don’t Trade Earnings
Before You Read This

2. 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.

3. 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.

4. 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).

5. 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.

6. 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.

7. 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?

8. 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.

9. 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.

10. 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).

11. 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.

12. 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).

13. After all, we are trying to figure out what the
implied move is (+/-).
The math:
The $345 call and the $345 put (straddle) have a
mid-price of $39.48. The stock price is $345.74

14. $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.

15. Break-even points:
$345 minus $39.48= $305.52
downside break-even
$345 plus $39.48= $384.48
upside break-even

16. 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

17. $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

18. 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.

19. 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.

20. 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.

21. ……

22. 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.

23. 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.

24. 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.

25. (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”)