MorningWord 4/23/15: I Remember This One Time… $NFLX $YHOO

by Dan April 23, 2015 9:19 am • Commentary

Single stock volatility is the headline grabber during earnings season. The potential for an out-sized nearly instantaneous gap in an underlying equity as the result of a single earnings press release can be an irresistible trade set up for those who view the stock market as more of a casino than a conduit for investment.  We spend a good bit of time during earnings season trying to line up qualitative and quantitative inputs, and attempt to arrive at an investment/trading conclusion prior to results as to whether or not fundamental expectations line up with the expected movement priced into options prices of the underlying stock.

As traders we seem to have a better memory for stock’s like Netflix (NFLX) which rallied 18% last Wednesday following its better than expected subscriber growth vs its implied move of about 9%, as opposed to Yahoo (YHOO) who’s shares declined only 1% yesterday following its results. It had an implied move of about 5.5%. The massive outliers are few and far between, but for some reason they hold a very special place in our memory. This is called confirmation bias.

The simple fact of the matter is that if you took a random group of 100 stocks in the S&P 500 (has to be random, you can’t feel “drawn” to the names, that’s another bias) and sold every implied move (the premium in options of the underlying that exists during an earnings period as opposed to the period where there is no scheduled event) over the course of an earnings period it would be a near certainty that you would make money.  We can leave the math to be explain by quants, but we think it is an important message to those looking to to make short term directional long premium bets into earnings. As we often warn, there are a lot of things you need to get right just to break-even, first and foremost direction, timing and magnitude of the move. You’d have better odds of always betting on black.

Which is why in most instances in and around earnings we detail overlay strategies for existing longs. If long holders sold options against their positions routinely during earnings it would also be a near certainty that this would at the very least be a risk mitigating strategy over time with a high likelihood of yield enhancement.

In our view there are three main uses for equity options. Yield enhancement, leverage and risk management.  When used in conjunction with an existing stock position we are fairly certain of their value as an overlay strategy, as a directional trading vehicle without a broader context or investment program we are less convinced, but at the very least we find options activity and price changes useful to gauge sentiment. And often when used speculatively or directionally within a defined risk parameter they are much better than trading the equity itself.