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How to Profit from Earnings News with Options
10/07/2010 12:01 am EST
Option investors have a unique ability to profit in the market no matter which direction a stock's price moves. A straddle is a great example of this kind of strategy. A straddle is market neutral, which means that it will work equally well in bear or bull markets. These trades have an extremely low probability of maximum loss and can earn big returns if a stock's price moves a lot.
Sometimes stocks move a lot very unexpectedly, and other times, we can predict this volatility. One of these predictable periods of volatility immediately follows earnings announcements. These happen every quarter and the news can affect a stock's price dramatically. Today, we will use a specific case study for using an option straddle the day before the earnings release for Google, Inc. (GOOG).
In order for a straddle to be successful, a stock's price needs to make a big move up or down. The “straddle” means that you are buying two options, a call and a put, with the same strike prices. Imagine that you are “straddling” both halves of the option chain sheet. A straddle is most frequently entered with the at-the-money strike prices.
In the example for GOOG, the stock is currently priced at $390 per share and the 390 strike price calls and puts cost a combined total of $45 per share, or $4,500 total to purchase.
If we imagined holding the straddle through to expiration, the stock would have to move at least $45 in one direction or the other to reach break even. Although this article is about short-term straddles, sometimes buying a straddle with a long expiration date can be an effective strategy.
This may sound a bit unusual to buy both a call and a put at the same time. New traders often assume that gains from one of the options will be offset by losses in the other. That is true to a point, however, eventually the losses from the losing option will be outpaced by the gains from the winning option.
For example, imagine that the stock breaks out to the upside, the call will begin gaining in value while the put loses value. As long as the call gains more than the put, the straddle will be profitable. That is also true in reverse if the stock begins to lose value. Because both options are long, they can only lose what was originally invested, while the winning side still retains the possibility of unlimited profits.
Because such a large move is needed to become profitable, it is more likely that the trade will conclude with a small loss. However, because the upside potential for long options is theoretically unlimited, a straddle trader is counting on the much larger wins to offset the more frequent losers.
Trading straddles during an earnings announcement ensures a high likelihood for volatility and inflated option prices. These are the offsetting opportunities and risks of the earnings straddle. If the stock moves a lot, the straddle would likely profit, however, if the stock doesn't move enough, the deflation in option prices following the announcement will create a loss.
These offsetting risks and opportunities are not surprising, and most short-term straddle traders anticipate more losing trades than winning ones. Long-term profitability rests on those outlier earnings releases in which the stock moves dramatically and large profits can be accumulated. In this case study, we're illustrating a straddle on GOOG that cost $45 per share, or $4,500 total. If we assume that the position was held until expiration, that means that the stock would have to move at least $45 per share up or down to reach break even.
Calculating the expiration break even is a reasonable way to estimate how far the stock needs to move to compensate for the deflation in the option prices following an earnings announcement. In this case, the stock did not move far enough to make the trade profitable, and any potential straddle traders are now faced with two alternatives for exiting the position:
1) Selling to Exit the Straddle Immediately
Option prices have declined the day after the earnings announcement, and currently, the 390 calls are worth $13.30 per share and the 390 puts are worth $20 per share. The total value of the straddle is $33.30 per share, or $3,330 dollars per straddle. Because this is an actively traded stock, there should be no problem selling to exit the straddle and moving on to a new opportunity.
2) Leaving One Leg of the Straddle Open for Speculation
Prices for this stock have moved to the downside, and if your analysis indicates that there is more opportunity within the new downtrend over the next few weeks, you may choose to leave the long put on while the call is exited. There is no obligation for the straddle buyer to have to exit both sides at one time. You may choose to "leg out" of the spread by selling one side first, anticipating that the other side will improve in value before expiration.
Options provide alternatives that can be used as market events unfold. A long straddle is a good example of how a spread can be modified and converted from a market-neutral position into an outright long position that can continue to profit if the market continues to trend. It is important to note that this is merely one use for the straddle trading strategy.
By John Jagerson of LearningMarkets.com
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