Schaeffer's Trading Floor Blog

A Guide to Earnings Season

Could NFLX's stunning earnings report translate into higher option prices all around?

by 4/24/2013 7:50 AM
Stocks quoted in this article:

Just some quick reminders as we wind our way through earnings season.

You'll see some estimates for earnings moves, both directionally and in terms of magnitude. You may even see some from me on Twitter/StockTwits. They just reflect what the options market expects to see once the news gets digested. It's based on the spread between the implied volatility (IV) in the nearer cycle(s) and the IV volatility of further cycles. The IV of further cycles is essentially a proxy for *normal* implied volatility, i.e. the IV we expect to see in the nearer cycle(s) with the news out.

As I've mentioned before, I use the Market Maker Move (MMM) number on the Thinkorswim trade screen, but they don't have a monopoly on this. Other services, or a relatively simple hand calculation, will give similar, but rarely identical, numbers. There's no prize for getting it exactly right, they're all just approximations as no human or machine can know exactly what the IV term structure will look like when the stock reopens.

And, most importantly, the number is not designed to get it exactly correct. It's effectively one standard deviation. As such, the stock will move less than the expected earnings move 68% of the time.

For example, say XYZ reports tonight. The MMM for XYZ is 8%. That suggests there's a 68% chance that XYZ will move under 8% tomorrow.

If XYZ moves 20% tomorrow, that doesn't mean the MMM was wrong. There's nearly one-third chance of an outlier move like that.

If you look at every name before and after earnings, about one-third will move beyond the number. That assumes the pricing is generally correct. If 40% to 50% move beyond the number, it's either too early and too small a sample size, or prices are simply too low. If the latter is the case, the market will likely bid up future names and will reach an equilibrium somewhere.

When a name blows way past the number, like Netflix, Inc. (NASDAQ:NFLX) on Monday, it will have an outsize impact on future pricing. In and of itself, it doesn't mean much. It's one company with unique characteristics; good news there doesn't really translate fundamentally to too many other names. But NFLX is a very high-profile name, and the move was so stunning it can't help but impact pricing in names yet to report.

And finally, remember: risks are not symmetrical. You face open-ended risk on options shorts, so even though a dedicated option-shorting strategy ahead of earnings will win about two-thirds of the time, the losses are bigger and the net expected gain is about 0.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.

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