Today we had a great example of a post earnings volatility crush in NFLX. The stock closed down 4.40% yet nearly all of the puts were absolutely crushed. The reason for this is the volatility premium  (or uncertainty) coming out of the option prices. John Marsland likes to call implied volatility the “excitement factor” and during earnings there is a lot of excitement and fear regarding how the numbers will come out. As a result implied volatility goes through the roof resulting in inflated options prices.

Generally implied volatility will gradually rise into earnings and then get crushed straight after the announcement as the uncertainty is taken out of the market. You can see a great example of this below with GOOG. The gold line shows implied volatility gradually rising into each earnings announcement and then getting crushed after the announcement. At the same time, if there is a big move in the stock, the historical volatility goes through the roof.

You can see the same thing happening today with NFLX. Implied volatility has dropped from the high 70s down into the low 40s.

Each earnings cycle there is a battle between market makers who have to price options and traders looking to profit from the volatility crush by selling strangles and straddles. Let’s use a simple example and assume you have a stock trading at $100. The $100 calls are trading at $5 and the puts are trading at $5. This tells us that the market makers are expecting a 10% move in the stock post earnings.

Yesterday NFLX was trading around $255. The $255 July 26 th calls were trading at about $21 and the $255 puts were around $15. If you take the average of the two, you can see that the market makers were predicting a move of $36 (regardless of direction) or around 14%. Today the stock closed down 4.5% and the $255 calls are now worth $2.60 and the $255 puts are worth $7.50. A trader selling the $255 strangle would have made about $26 per spread, a resounding win for the short straddle trader over the market makers!

Notice also, that even though the stock had a pretty big drop at 4.5%, that all of the puts have dropped in value due to the volatility premium coming out of the prices.

Trading options on individual stocks is risky, especially with volatile stocks like NFLX, but it’s interesting to see these types of scenarios play out. If you look back at NFLX over the last few years, you can see they have had some massive post earnings moves, so you can understand why the market makers were expecting a big move.

Here are a couple of other articles on post earnings volatility drops in case you feel like some more reading on the subject: