Using an Option Straddle to Profit on Earnings
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Dan Passarelli MarketTaker .com |
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Want to take advantage of a big move in a stock while limiting the potential risk? First, what could trigger a major upside (or downside) move for a stock? News. You want to find a major news event, but you can’t predict the future, right? You can’t tell when a stock is going to be upgraded or downgraded, or when it is going to announce that it has to lay off or hire employees. That said, there is one major news event on most stocks that occurs like clockwork (or at least on a reasonably pre-determined schedule): earnings reports.
The Straddle
Though traders generally know when earnings will be, the result of the earnings announcement remains unpredictable. So how can options help make the most out of a major news event like earnings? By employing an option straddle. Much like the definition suggests, this strategy straddles the line on a stock, offering profitability on either side. In order to execute an option straddle, a trade would purchase both a call and a put, at the same strike price and same expiration date.
Let’s say a company is currently trading at $50. A trader decides to purchase an at-the-money, 50 call for 3.00 and the same strike put for 2.90. The total premium paid, therefore, is 5.90. For the position to break even, the stock must advance to $55.90 (strike price + premium paid) or to drop past to $44.10 (strike price – premium paid). Between those prices, the trade is a loser. Bottom line: this trader needs a big move. That said, the trade has a limited maximum loss of $5.90 (the premium). That loss occurs if the underlying stock’s price is at $50 (equal to the strike price) at expiration. The maximum profit is unlimited to the up side. And if the stock drops, it is still substantial, as the stock can only drop to zero.
When using a straddle ahead of earnings, it is a rule of thumb to buy the straddle at least two weeks before the earnings event. Why so far ahead? To capitalize on any volatility ahead of the earnings announcement. The effect of time decay on a straddle is fairly small over a two-week period. But the price of the options could rise prior to the announcement because of a rise in implied volatility.
Implied volatility rising is a fairly common occurrence preceding an earnings announcement. But high implied volatility can sometimes be problematic for traders who purchase straddles just before earnings, say a day or two ahead. High implied volatility makes options very expensive. And worse, just as the volatility can rise before the event, it can get crushed after. That means the price of the straddle can fall drastically even if there is a small move in the share price. Timing when to buy straddles is a balancing act; so be careful! Traders considering buying a straddle are looking for major stock move, big enough to offset any potential volatility crush.
Why Earnings?
So, when trading a straddle, the trader really needs a sizeable move in either direction. While it is rare that a stock price jumps or falls 10 percent or more following earnings, the scenario is not unheard of. But it is uncommon that the stock will remain at the same price after earnings are released.
Conclusion
A straddle can be used in conjunction with a major news event, like earnings, if used carefully. A straddle will allow you to hedge your bets and capitalize on the increased volatility that can crop up when the news surfaces. Learning to use a straddle effectively will take some study and some practice. But a straddle is a great tool to have to play a stock during a volatility event.
Dan Passarelli is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLCTM. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.