Warning to Options Traders Looking at NetFlix Earnings

Jan. 26, 2011 - PRLog -- One of the hardest things for me to remember is not to believe everything I see. I am a sucker for the latest “can’t lose” strategy supported by the experts. This morning I ran across a trade that looked too good to be true. I think it is, but I think it is instructive to walk through the potential hidden land mine. The event is the Wednesday afternoon release of NFLX earnings but there is a hidden trap for option traders using one commonly used earnings play structure.

The construction of the play is that of a “double calendar” spread. The underlying profit engine is an attempt to exploit the routinely seen spike in implied volatility (IV) of the options series most closely following earnings release. In this case, NFLX has weekly options which expire 48 hours after the scheduled announcement.

In order to understand the situation, let’s walk through the components step-by-step. First, is the routinely observed spike in IV seen as earnings release approaches present? As shown in the options pricing matrix below, the IV of the weekly options is substantially higher than the next series in time, the February monthlies.

Next, we need to get an idea of the magnitude of the price movement expected by option traders. This price range can be imputed from the break even points of the at-the-money straddle in the front most options. As shown in the graph below, this analysis gives a current expected price range of 167-203 following earnings release.

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