by Ian Harvey
This simple options strategy – straddles - is perfect for a company about to report earnings.
As you are aware, that in trading there are numerous sophisticated trading strategies designed to help traders succeed regardless of whether the market moves up or down. Some of the more sophisticated strategies, such as iron condors and iron butterflies, are legendary in the world of options. They require a complex buying and selling of multiple options at various strike prices. The end result is to make sure a trader is able to profit no matter where the underlying price of the stock, currency or commodity ends up.
However, one of the least sophisticated option strategies can accomplish the same market neutral objective with a lot less hassle - and it's effective. The strategy is known as straddles.
Straddles are an options strategy with which the investor holds a position in both a call and put with the same strike price (at-the-money) and expiration date.
With options, you buy a call if you expect the market to go up, and you buy a put if you expect the market to go down. Straddles, however, are strategies to use when you're not sure which way the market will go, but you believe something big will happen in either direction.
For example, let's say you expect a big move to occur, either up or down, based on whether the company reports a positive surprise or a negative surprise. With these strategies, you can make money in either direction without having to worry about whether you guessed correctly or not.
Example: Let's say a stock was trading at $100 a few days before their earnings announcement. So you decide to put on a straddle by buying:
• the $100 strike call
• and the $100 strike put
Because you only plan on being in the trade for a few days (to maybe a few weeks), you decide to get into the soon-to-expire options.
It is important to note that when you are playing one side of the market it is much more strategically sound to buy more time and get in-the-money options.
But when playing both sides of the market simultaneously for an event you expect to take place in the near immediacy, the opposite is best. This is due to the fact that at expiration, your profit is the difference between how much your options are in-the-money, minus what you paid for them. So if you don't need a lot of time, this keeps the cost down and your profit potential up.
If you paid $150 for an at-the-money call option that will expire shortly, and another $150 for an at-the-money put option that will expire shortly, your cost to put on the trade was $300 (not including transactions costs). If that stock shot up $10 as a result of a positive earnings surprise, that call option that you paid $150 for would probably now be worth $1,000. And that put option would be worth zero ($0).
Therefore, if the call, which is now $10 in-the-money, is worth $1,000; then subtract the $150 you paid, and that gives you an $850 profit on the call.
The put, on the other hand, is out-of-the-money, and is worth nothing, which means you lost $150 on the put.
Add it all together, and on a $300 investment, you just made a profit of $700. Pretty good—especially for not even knowing which way the stock would even go.
However, if you paid more for each side of the trade, those would be extra costs to overcome. But by keeping each side's cost as small as reasonably possible, that leaves more profit potential on the winning side and a smaller loss on the losing side.
Moreover, if the stock stays flat (in other words, the big move you expect doesn't materialize, thus resulting in both sides of the trade expiring worthless), your cost of the trade was kept to a minimum.
When Straddles Work Best
The option strategy works best when there are at least one of these three criteria present:
• The market is in a sideways pattern.
• There is pending news, earnings or another announcement.
• Analysts have extensive predictions on a particular announcement.
Analysts can have tremendous impact on how the market reacts before an announcement is ever made. Prior to any earnings decision or governmental announcement analysts, do their best to predict what the exact value of the announcement will be. Analysts may make estimates weeks in advance of the actual announcement, which inadvertently forces the market to move up or down. Whether the prediction is right or wrong is secondary to how the market reacts and whether your straddle will be profitable.
After the actual numbers are released, the market has one of two ways to react: The analysts' prediction can add either to, or decrease the momentum of the actual price, once the announcement is made. In other words, it will proceed in the direction of what the analyst predicted or it will show signs of fatigue. Properly created straddle, short or long, can successfully take advantage of just this type of market scenario. The difficulty occurs in knowing when to use short or a long straddles. This can only be determined when the market will move counter to the news and when the news will simply add to the momentum of the market's direction.
The Risks of a Straddles Strategy
The stock price must move significantly if the investor is to make a profit. As shown in the top diagram, if only a small movement in price occurs in either direction, the investor will experience a loss. As a result, this strategy can be extremely risky to perform if not handled correctly or the market becomes incredibly cantankerous. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.
The strategy of buying straddles, by its very nature, should be looked at as a short-term trade. If the outcome of the event that prompted you to get into this strategy in the first place, which is the case at present – earnings season - now has you strongly believing that a continuation of the up-move or down-move is in order, you could then exit the straddle and move into the one-sided call or put and apply the in-the-money and more-time rules for those.
There is a constant pressure on traders to choose to buy or sell, collect premium or pay premiums, but the straddles strategy is the great equalizer. Straddles allow a trader to let the market decide where it wants to go.
The classic trading adage is "the trend is your friend".
Take advantage of one of the few times that you are allowed to be in two places at once with both a put and a call.