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President Trump gave the markets something to think about it when he told reporters yesterday that the U.S. has a long way to go to secure a trade deal with China, and even hinted at imposing further tariffs on them. 

And while that is bound to get some attention from traders for the next few days, it won’t be the main focus. 

You see, earnings season has started… and it’s running fast this week. Tonight after the close, Netflix, IBM, eBay, United Rentals, Kinder Morgan, and Alcoa will be releasing their quarterly results (Q2). 

For some of these stocks, earnings day will be the most volatile trading of the year…

… and as traders, we welcome it. 

However, one mistake I see traders make is that they don’t make adjustments when they’re trading options on stocks that have earnings. 

You see, it’s no secret that stocks are expected to be more volatile during earnings, and the options market “prices it in.”

(Don’t let earnings season stress you out, make sure you understand the risks involved and are comfortable taking them)

Furthermore, there is one statistic that options traders use to gauge how big or small a move is expected to be in the stock during its earnings day. 

If you don’t know what that statistic is, how to analyze it, and use it to make informed trading decisions, then you’re putting yourself in a significant disadvantage.

Of course, I’m not going to leave you hanging. Not only am I going to answer those questions for you, but I’m also going to breakdown what the options market is telling us about tonight’s Netflix earnings. 

 

This One Statistic Can Tell You What the Market is Expecting

 

Well, it’s earnings season… and traders will be looking at one statistic to get an idea of what the market is looking for. I’m talking about the “implied move”, or “implied straddle”.

Now, if you don’t know what a straddle is… it’s simply a strategy in which you buy calls and puts with the same expiration dates and strike price. If you purchase a straddle… you want the stock to have a big move in either direction.

That said, there are some traders who actually buy an at-the-money (ATM) straddle ahead of an earnings event. Before you try to go out and do that… there are some things you need to know.

If you need to brush up on options trading, click here to claim my free eGuide – 30 Days to Options Trading.

 

Calculating the Expected Move

 

Calculating the implied move is actually really easy… all you need to do is find the ATM calls and puts for contracts that include the earnings date.

For example, Netflix Inc. (NFLX) is set to report earnings after the bell, and the stock closed at $365.99, so look to the $365 calls and puts.

If you look at Yahoo Finance, you can find the “Straddle” view of the options chain.

Now, here’s a look at the options that traders use to calculate the implied move:

Now, if you notice in the options chain above, there are two prices here: $13.95 for the $365 calls and $13.20 for the $365 puts. Well, you would simply add the two up and that’s the price of the straddle. 

Thereafter, you would divide the price of the ATM straddle by the stock price. So the $365 straddle expiring this week was $27.15, as of yesterday’s close. That means the market is looking for a 7.42% move ($27.15 / $365.99).

What that means is traders are expecting NFLX to move around 7.42% after its earnings announcement. However, that doesn’t mean the stock can’t move more or less than that value.

Now, what typically happens after an earnings event is the “vol crush”, or implied volatility crush.

 

Volatility Crush

 

If you don’t know, an earnings event is filled with uncertainty. You see, companies provide the market with a look into how it’s been performing… and they might provide guidance or make comments on a conference call. 

Due to all this uncertainty, the implied volatility in options actually rises ahead of the event. 

You see, an option’s price can be broken down into two components – intrinsic value and extrinsic value. Intrinsic value is just the value of the option in relation to the stock on the expiration date of if you exercise those options.

However, it’s the extrinsic value we really care about here. 

Heading into an earnings event, traders get excited and place their bets on either puts or calls… and the market will price in a specific move (the market is expecting around a 7.42% move for NFLX). 

Since there’s potential volatility, traders are looking to potentially make money after the report… and it actually increases the demand for options in the stock.

However, what happens after an earnings event?

Well, the cat is out of the bag, as there is not a whole lot of uncertainty anymore… so the implied volatility in options actually gets crushed (there is a lot of supply in the market now, and traders are looking to get out of those options.)

Now, no matter how the market digests the NFLX earnings report, theoretically, if you buy the straddle heading into NFLX earnings and it moves more than 7.42%, you would make money.

On the other hand, if you short the straddle (sell the $365 puts and calls expiring this week), and if NFLX moves less than 7.42%, you would theoretically make money.

That said, are you a buyer or seller of the straddle? Comment with your answer below.

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