Buying Straddles into Earnings

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results.

The strategy here is to buy the straddle two to three weeks ahead of earnings. Significant price movement is necessary for a straddle to make money and in the case of the earnings play, there are three events that can occur during this period which can create price movements sufficient enough to generate a profit.

Prior to the earnings, excitement abound and the underlying stock price may trade up or down ahead of the actual earnings due to increased speculation. Sometimes, price may move so much that you may be able to exit the position with a small profit without holding into earnings.

Immediately after the earnings annoucement, stock price can often gap up or down 3% to 5%, depending on the report. Movements of 5% to 10% are seldom but not uncommon. Rare is the case when stock price remains unchanged.

A third event, unlikely but not impossible, is the profit warning that may be issued a few weeks prior to the earnings report. Large downward movements are typical following such warnings and are usually big enough to allow for a profitable exit.

Unless you are very certain that the gap up or down after the report will be huge, never buy the straddle just one day before earnings as this is the time when the premiums of at-the-money options get bid up very high due to heightened anticipation. Do your homework and scout for companies announcing earnings two to three weeks in advance. Lookout for stocks displaying a history of gap movements during earnings by examining the historical price chart.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

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Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

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Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

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Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

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Warrior Trading Blog

Top 3 Tips On Buying A Straddle For Earnings

Reliable opportunities for big profits can be tough to come by but if you play your cards right and do your homework you can find some excellent opportunities during earning season.

One play we really like is the long straddle, which involves buying an at the money call and put. There are a couple of different ways to play this trade so read on to find out why this trade can be a reliable source of profits during earning season!

The Long Straddle

A long straddle is a simple yet sophisticated options position that involves buying both at the money call and put, where the strike price of both options is close to the current stock price, with the same expiration date, usually going past the earnings date.

The theory behind the long straddle is that the buyer of the position expects a high degree of volatility after the company releases earnings, but they are unsure in which direction the price will change.

The long straddle provides positive exposure to a significant price move in either direction, with a chance to profit as long as the price change is large enough to cover the premiums regardless of the direction of the change.

With this strategy you have two break even spots with the first one being the strike price plus the net debit paid and the other being the strike price minus the net debit paid.

So for example, if you bought a long straddle on Netflix with a strike price of $195 for a net debit of $17.45 ($1,745 total cost) then your breakeven points would be $212.45 and $177.55. You would need the stock to move above or below those prices in order to be profitable but keep in mind that theta (time decay) and implied volatility will affect prices before earnings are announced.

In theory you have unlimited profit potential because the stock can keep going up, but we know that’s never the case. The main goal behind this strategy is to capture a large move in either direction or let implied volatility juice up premiums which I will go over more below.

Stocks With High Volatility On Earnings Reports

The straddle before an earnings report trade works best when used with stocks that have a reliable history of significant price movements after an earnings report. These are usually big name stocks with large market caps, high trading volumes and variable business models.

Think of companies such as Amazon, Apple and Netflix. These companies all have volatile earnings with price movements regularly reaching more than 5% up/down post earnings. These volatile names usually build up anticipation and with that comes high implied volatility. Implied volatility is a key metric in pricing options so when that spikes up like it typically does before earnings we can also see a hefty rise in option premiums even if the stock doesn’t move much!

In the implied volatility chart above you can how the yellow line spikes and then plummets. Can you guess what is causing that? Thats right! Earnings. This spikes in implied volatility help juice up premiums which means you could potentially take profits without even holding through earnings.

Buy Your Straddle Early

The price of an option is in large part a product of the expected volatility of the underlying stock’s price. The nearer that you get to the earnings report, the higher the price of the options in your straddle will become because of implied volatility. Therefore, it is best to buy your options 2 to 3 weeks or even more before the earnings report, so that you can avoid the increase in premium that occurs as the date approaches.

You also pay more for longer dated options, so you do not want to buy them too early or or you will pay a higher premium for the duration effect of the options without any price advantage on the volatility effect.

Learning how to balance the volatility and duration effects when selecting options for your derivatives trades is one of the essential skills to successful derivatives trading, so spending some time working on this will not be wasted.

A Great Entry Level Derivatives Trade

The long straddle on an earnings report is a great entry level derivatives trade for exposing new derivatives traders to the concepts, technical aspects and underlying theory involved in successful derivatives trading. Derivatives allow you to create highly sophisticated positions and to make trades that would otherwise be impossible or much less reliable using more traditional trading techniques.

Once you have successfully accomplished a few long straddle on an earnings report trades, you will be ready to graduate to more complex and nuanced derivatives trades with the knowledge and confidence to succeed.

Final Thoughts

As we near some big earning dates for companies like Netflix, Facebook and Amazon it is important to plan your trade out carefully and get a good price on your options. It’s always a good idea to look at implied volatility charts to make sure you aren’t over paying which you usually won’t be if you buy them two to three weeks in advance.

Another important thing to keep in mind while playing earning straddle’s is that even though you can make a substantial amount if the stock makes a huge move following earnings, it is far more reliable to buy two to three weeks before earnings and let implied volatility juice up the premiums. Then you could collect profits before earnings and not risk getting burned because even if the stock makes a big move, if it isn’t enough the premium in the options will be sucked out as implied volatility plummets.

Let us know if you have any questions in the comments below!

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Barber, Brad & Lee, Yong-Ill & Liu, Yu-Jane & Odean, Terrance. (2020). Do Day Traders Rationally Learn About Their Ability?. SSRN Electronic Journal. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2535636

Garvey, Ryan and Murphy, Anthony, The Profitability of Active Stock Traders. Journal of Applied Finance , Vol. 15, No. 2, Fall/Winter 2005. Available at SSRN: https://ssrn.com/abstract=908615

Douglas J. Jordan & J. David Diltz (2003) The Profitability of Day Traders, Financial Analysts Journal, 59:6, 85-94, DOI: https://www.tandfonline.com/doi/abs/10.2469/faj.v59.n6.2578

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Profit From Earnings Surprises With Straddles And Strangles

As a general rule, the price of any stock ultimately reflects the trend, or expected trend, of the earnings of the underlying company. In other words, companies that grow their earnings consistently tend to rise over time more than the stocks of companies with erratic earnings or losses. This is why so many investors pay close attention to earnings announcements.

Every quarter, U.S. companies announce their latest earnings and sales results. Sometimes, this information is entirely in line with expectations and the market basically shrugs its collective shoulders. At other times, however, a company unleashes an earnings surprise, and the stock market reacts in a decisive fashion. Sometimes, the reported results are much better than expected – a positive earnings surprise – and the stock reacts by advancing sharply in a very short period of time to bring the price of the stock back in line with its new and improved status. Likewise, if a company announces earnings and/or sales that are far worse than anticipated – a negative earnings surprise – this can result in a sharp, sudden decline in the price of the stock, as investors dump the shares in order to avoid holding onto a company now perceived to be “damaged goods”.

Either scenario can offer a potentially profitable trading opportunity via the use of an option trading strategy known as the long straddle. Let’s take a closer look at this strategy in action. (To learn more, read Surprising Earnings Results.)

The Mechanics of the Long Straddle
A long straddle simply involves buying a call option and a put option with the same strike price and the same expiration month. In order to use a long straddle to play an earnings announcement, you must first determine when earnings will be announced for a given stock. You might also analyze the history of the stock itself to determine whether it is typically a volatile stock and if it has previously had large reactions to earnings announcements. The more volatile the stock and the more prone it is to react strongly to an earnings announcement, the better. Assuming you find a qualified stock, the next step is to determine when the next earnings announcement is due for that company and to establish a long straddle before earnings are announced. (To learn more, read Straddle Strategy A Simple Approach To Market Neutral.)

Setting Up the Long Straddle Position

When to Enter
When setting up the long straddle, the first question to consider is when to enter the trade. Some traders will enter into a straddle four to six weeks prior to an earnings announcement with the idea that there may be some price movement in anticipation of the upcoming announcement. Others will wait until about two weeks prior to the announcement. In any event, you should generally look to establish a long straddle prior to the week before the earnings announcement. This is because quite often, the amount of time premium built into the price of the options for a stock with an impending earnings announcement will rise just prior to the announcement, as the market anticipates the potential for increased volatility once earnings are announced. As a result, options may often be less expensive (in terms of the amount of time premium built into the option prices) two to six weeks prior to an earnings announcement than they are in the last few days prior to the announcement itself.

Which Strike Price to Use
In terms of deciding which particular options to buy, there are several choices and a couple of decisions to be made. The first question here is which strike price to use. Typically, you should buy the straddle that is considered to be at the money. So, if the price of the underlying stock is $51 a share, you would buy the 50 strike price call and the 50 strike price put. If the stock was instead trading at $54 a share, you would buy the 55 strike price call and the 55 strike price put. If the stock was trading at $52.50 a share, you would choose either the 50 straddle or the 55 straddle (the 50 straddle would be preferable if by chance you had an upside bias and the 55 straddle would be preferable if you had a downside bias). Another alternative would be to enter into what is known as a strangle by buying the 55 strike price call option and the 50 strike price put option. Like a straddle, a strangle involves the simultaneous purchase of a call and put option. The difference is that with a strangle, you buy a call and a put with different strike prices. (To learn more, read Get A Strong Hold On Profit With Strangles.)

Which Expiration Month to Trade
The next decision to be made is which expiration month to trade. There are typically different expiration months available. The goal is to buy enough time for the stock to move far enough to generate a profit on the straddle without spending too much money. The ultimate goal in buying a straddle prior to an earnings announcement is for the stock to react to the announcement strongly and quickly, thus allowing the straddle trader to take a quick profit. The second-best scenario is for the stock to launch into a strong trend following the earnings announcement. However, this would require that you give the trade at least a little bit of time to work out.

Shorter-term options cost less because they have less time premium built into them than longer-term options. However, they also will experience a great deal more time decay (the amount of time premium lost each day due solely to the passage of time) and this limits the amount of time that you can hold the trade. Typically, you should not hold a straddle with options that have less than 30 days left until expiration because time decay tends to accelerate in the last month prior to expiration. Likewise, it makes sense to give yourself at least two or three weeks of time after the earnings announcement for the stock to move without getting into the last 30 days prior to expiration. (To learn more, read The Importance Of Time Value.)

For example, let’s say that you plan to put on a straddle two weeks – or 14 days – prior to an earnings announcement. Let’s also say that you plan to give the trade two weeks – or another 14 days – after the announcement to work out. Lastly, let’s assume that you do not want to hold the straddle if there are fewer than 30 days left until expiration. If we add 14 days before plus 14 days after plus 30 days prior to expiration we get a total of 58 days. So in this case, you should look for the expiration month that has a minimum of 58 days left until expiration.

Example Trade
Let’s consider a real-world example. Apollo Group (Nasdaq:APOL) was due to announce earnings after the close of trading on March 27, 2008. On February 26, a trader might have considered buying a long straddle or a long strangle in order to be positioned if the stock reacted strongly one way or the other to the earnings announcement. In this case, APOL was trading at $65.60 a share. A trader could have bought one contract each of the May 70 call at $5 and the May 60 put at $4.40. The total cost to enter this trade would be the cost of the two premiums, or $940. This represents the total risk on the trade. However, the likelihood of experiencing the maximum loss is nil because this trade will be exited shortly after the earnings announcement and thus well before the May options expire. (To learn more, read Understanding Option Pricing.)

If you look at Figure 1, you will see the price action of APOL through February 26 on the left and the “risk curves” for the May 70-60 strangle on the right. The second line from the right represents the expected profit or loss from this trade as of a few days prior to earnings. At this point in time, the worst-case scenario if the stock is unchanged is a loss of approximately $250.

Figure 1: Apollo Group stock and risk curves

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