Trading Earnings with Option Strangles

04/08/2011 7:00 am EST

Focus: OPTIONS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Traders can profit big from a stock’s post-earnings price swing—regardless of the direction—by constructing an option strangle, and there’s an added benefit: Risk is limited in case a move doesn’t materialize.

Earnings season is fast approaching, with blue-chip bigwig Alcoa Inc. (AA) set to unofficially kick things off on Monday (April 11). As most of you already know, earnings reports can often translate into volatility on the charts, but options players should have no fear.

There are plenty of ways to capitalize on a monstrous move in either direction without putting heaps of cash on the line.

One such way to profit from a stock's post-earnings price swing is the long strangle, which is typically implemented by purchasing an equal amount of slightly out-of-the-money calls and puts with the same expiration date, resulting in a net debit.

The strangle will generate a profit as long as the underlying breaches one of two breakeven rails before expiration: The put strike less the net debit on the downside, or the call strike plus the net debit on the upside.

In either case, the intrinsic value of the in-the-money option will exceed the loss incurred from the losing option, resulting in a boost to your bank account.

But what if the stock remains stagnant through options expiration? One of the primary appeals of the long strangle is that your risk is limited, with the initial premium paid for the options representing the maximum potential loss on the play (excluding brokerage fees).

That said, let's jump into a hypothetical long strangle on AA, which just tagged a new multi-year high of $18.03 on Tuesday (April 5).

As such, we're going to buy the April 17 put, which was last asked at $0.17, or $17 per contract (as each option contract represents 100 shares).

(NOTE: Be sure to check current pricing prior to entering a trade.)

Meanwhile, for the other half of our trade, we're going to purchase the April 18 call, which recently changed hands for $0.50, or $50 per contract. Combining the premium paid for the two options, our long strangle is initiated for a net debit of $0.67, or $67, per pair of options.

chart
Click to Enlarge

In order to reap a reward on the play, we need the shares of Alcoa to do one of two things before April-dated options expire: 1) Retreat beneath the $16.33 level (put strike minus net debit), or 2) Power north of the $18.67 level (call strike plus net debit).

However, as alluded to earlier, even if AA remains glued to the $18 level through the options' lifetime, the most we can possibly lose (at the time of this writing) is capped at the $67 paid to construct the long strangle.

By Andrea Kramer, contributor, Schaeffer’s Trading Floor Blog

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