profit from earnings surprises Setting up the long straddle position The mechanics of the long straddle option straddle option strangle Setting up the long straddle position The mechanics of the long straddle option straddle option strangle profit from earnings surprises option strangle
Generally speaking, the price of any stock ultimately reflects the trend—or anticipated trend—of the underlying company’s earnings. In other words, over time, stocks of companies with stable earnings tend to increase more than those of companies with irregular profits or losses. This explains why earnings reports are so closely watched by investors.
The Securities and Exchange Commission (SEC) mandates that publicly traded U.S. businesses report their most recent earnings and sales figures every quarter. But on occasion, a company will announce unexpected earnings, and the stock market will respond forcefully. When the reported results are significantly better than anticipated—a positive earnings surprise—the stock may react by rapidly rising in order to bring the price of the stock back in line with its improved situation.
Similar to the previous example, if a company reports earnings and/or sales that are significantly lower than expected—a negative earnings surprise—this can cause a sharp, sudden decline in the price of the stock as investors sell their shares to avoid holding onto a company that is now viewed as “damaged goods.”
Using the long straddle option trading method, any scenario can present a potentially lucrative trading opportunity. Let’s examine this tactic in action more closely.
• Straddles and strangles are common options strategies that involve buying (selling) a call and a put of the same underlying and expiration.
• Long straddles and strangles profit from large and volatile price swings, either to the upside or to the downside.
• A short straddle or strangle is profitable when the underlying price experiences low volatility and does not move much come expiration.
The Mechanics Of The Long Straddle
Purchasing a call option and a put option with the same strike price and expiration month is a long straddle. Finding out when earnings for a certain stock will be announced is the first step in using a long straddle to play an earnings announcement.
You might also research the stock’s past to see whether it has historically reacted strongly to earnings announcements and whether it is normally a volatile stock. The stock should be as volatile as possible and more likely to react violently to an earnings report. The next stage, if you have found a qualified stock, is to find out when the company’s next earnings announcement is scheduled and to set up a long straddle before the results are disclosed.
Setting Up The Long Straddle Position
The first thing to think about while putting up a long straddle is when to enter the trade. Four to six weeks before an earnings announcement, some traders will enter a straddle with the expectation that there may be some market movement in anticipation of the forthcoming announcement.
Others will hold off until about two weeks before the announcement. In any case, you should generally try to set up a long straddle before the earnings announcement. This is because the amount of time premium built into the price of options for a stock with an impending earnings announcement will often rise just prior to the announcement, as the market anticipates increased volatility once earnings are announced.
As a result, two to six weeks before to an earnings announcement, as opposed to the final few days before the announcement itself, options may frequently be less expensive (in terms of the amount of time premium incorporated into the option prices).
Which Strike Price To Use
There are several options and decisions to be made when deciding which specific options to purchase. The first question is which strike price should be used. You should typically buy the straddle that is considered to be at the money. So, if the underlying stock is $51 per share, you would buy the 50 strike call and the 50 strike put. If the stock was trading at $54 per share, you would purchase the 55 strike call and the 55 strike put. If the stock was trading at $52.50 per share, you would select either the 50 or 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 option is to enter a strangle by purchasing the 55 strike price call option and the 50 strike price put option. A strangle, like a straddle, entails the simultaneous purchase of a call and put option. The difference is that you buy a call and a put with different strike prices in a strangle.
Which Expiration Month To Trade
The next decision is which expiration month to trade in. Various expiration months are usually available. The goal is to buy enough time for the stock to move far enough for the straddle to generate a profit without spending too much money. The ultimate goal of purchasing a straddle prior to an earnings announcement is for the stock to react strongly and quickly to the announcement, allowing the straddle trader to profit quickly. The stock could enter a strong trend following the earnings announcement, which would be the second best scenario. However, this would necessitate giving the trade at least some time to work out.
Shorter-term options are less expensive because they have a lower time premium than longer-term options. They will, however, experience significantly more time decay (the amount of time premium lost each day due solely to the passage of time), limiting the amount of time you can hold the trade. Generally, you should not hold a straddle with options that expire in less than 30 days because time decay accelerates in the last month before expiration. Similarly, it is prudent to allow at least two or three weeks after the earnings announcement for the stock to move without entering the final 30 days before expiration.
Assume you intend to execute a straddle contract two weeks—or 14 days—before an earnings announcement. Assume you intend to give the trade two weeks—or another 14 days—to work out after the announcement. Finally, assume you do not want to hold the straddle if there are less than 30 days until expiration. We get 58 days if we add 14 days before, 14 days after, and 30 days before expiration. In this case, you should look for an expiration month with at least 58 days until expiration.
The Bottom Line
In the past, an investor or trader would analyse a company’s earnings prospects and, based on that analysis, would either buy the stock (if he thought the earnings would grow) or stand aside (if he thought the earnings would be disappointing). A trader or investor can now profit from an earnings announcement without taking a position. A trader can use a long straddle or strangle to profit from expected price movement if they have reason to expect an earnings surprise or if a stock has a history of reacting strongly to earnings announcements.
A sizable profit is possible if the stock experiences a sharp price movement in either direction. Furthermore, if the trade is properly positioned (that is, with enough time until expiration) and managed (that is, exited reasonably soon after the earnings announcement), the risk on the trade is typically quite low. To summarise, this strategy is yet another way to use options to capitalise on unique opportunities in the stock market.
Profit From Earnings Surprises With Straddles And Strangles
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