NFLX Pre-earnings Strangle

1/28/13

• Selection criteria:
• Underlying must normally experience a 2:1 volatility expansion prior to earnings
• Trade:
• 14 days before earnings (10 trading days)
• BTO a Strangle (long Call + long Put) at .10 delta
• STC day before earnings

NFLX last reported earnings on 1/22/13 after market close. On that day the Jan4 options had the highest IV at 149%. Using thinkBack we can buy a strangle on 1/8/13 when the Jan4 options had an IV of 75%. The .10 delta points to the 280P and the 425C.

The 425C has a mid price of 1.93 while the 280P is 3.07, giving us a TCOT of 4.99. In two weeks NFLX only moved around 7 points, from 340.99 to 333.73, while the expected 16-day move was over 43. So by 1/22/13 the 425C is only worth .06 and the 280P is only 1.53.

I added in the 2 options separately to better see the change in premium. You can see the value of the strangle is around 1.59 making a net loss of 3.40 since open.

Why was this trade a loser?

1. We paid 4.99 for an OTM spread that will be worth zero just 2 days after earnings.
2. NFLX needed to move close to one of our strikes, 60-85 points, but only moved 7.
3. Theta decay wipes out any vol expansion

Let's look at the vol expansion. After 1 week (1/15) vega of the 280P dropped from .13 to .11, so let's call it .12. At the same time IV increased from 15 points, from 78% to 93%. Quick and dirty math gives us roughly a 1.80 premium increase due to vol expansion.

During that same week theta increased from -.31 to -.53, a roughly -.42 average. Over the 5 trading days 2.10 in premium was lost, wiping out the 1.80 gained through vol expansion.

It gets worse the second week of the trade. Theta increases to -1.07 while vega dropped to .04, plus, the biggest vol expansion didn't occur until 2 days before earnings when vega was so small.

What happens if you open the strangle sooner, say 3 weeks before earnings? Unless NFLX moved much during that earlier week, you'll end up with similar strikes, pay more time premium, and still end up with a strangle that's only worth 1.59 before earnings.