Well, it is here again – report card time for America’s corporate sector. Four times each year, investors get to hear details about the health of the
companies they invest in. We get to see how well our companies performed in the past quarter as well as what the management teams forecast in the
foreseeable future. The reporting of these metrics often causes volatile moves in the share prices for these companies as investors determine if the
reports show shares to be undervalued or overvalued upon details of the results. Those of us utilizing equity options as trading vehicles have ways to
potentially profit from these sharp fluctuations in share values. Let’s visit the straddle/strangle as one tool to use during earnings season.
The straddle/strangle combines a long put option and a long call option in a single trade. A straddle is created when the both the call and put options are
at the same strike price, typically when the underlying equity is trading at that strike price. When the price of shares is between available strikes,
traders can utilize options at different strike prices surrounding the equity share price. The long call provides profitability if the equity goes up in
value while the long put will be profitable if the equity goes down in value. Sounds contradictory right? The idea behind this structure is that very quick
and large equity price change will cause one option to be so profitable that it will not only cover the loss on the losing side of the trade but also carry
overall profitability for this structure. It is a way to trade earnings without attempting to determine equity direction ahead of the event. We don’t care
which way the equity moves as long as it moves largely in one direction or the other. Let’s look at an example.
XYZ is trading at $23.81/share two days ahead of its earnings event. Looking at the chain for August 2013, we can create a strangle by buying the strike 24
call for .58 and the strike 23.00 put for .48. The total debit/risk in the trade is 1.06. How can this trade make money? If XYZ makes a substantial move
after earnings, one of these options will be very profitable while the other will lose most if not all of its value. The long call has a delta of +.47
meaning that it will make $.47 for each dollar that XYZ goes up. The long put has a delta of -.33 meaning that it will make $.33 for each dollar that XYZ
goes down. If XYZ goes up $1.00 on Wednesday, what will this trade potentially look like based on these delta calculations? The long call will be the
winner here as it will increase in value by $.47. The long put will lose $.33 of its value on the bullish move. This makes the long call worth about $1.05
and the long put worth $.15. We paid $1.05 initially on the trade so we would be slightly profitable (about $.15 or so) with the potential for further
profitability if XYZ continues higher. Sounds great right? Well, it’s not quite this simple. We also have to take into account another factor in options
pricing that will greatly impact this trade – vega, the greek for implied volatility.
As we approach earnings, the options market begins to price in the potential for violent equity movement after the report through an increase in implied
volatility. This causes premiums on options to increase. Remember that this structure involves buying two options. When we place this trade shortly before
the earnings event, we will be buying these options after this price inflation in premium has already occurred. Once the unknown becomes known in the
report, implied volatility plummets as there is now a much lower level of anxiety about just how much the equity may change in its price – the change has
occurred! We call this phenomenon “IV crush”. In our XYZ example, vega – the greek for IV – tells us that both our long call and long put will lose about
$.025 – 2 ½ cents – for each 1% drop in IV. Let’s say that IV drops 5% after earnings – not a particularly large crush but material nonetheless. This means
that each of our options will lose around $.12. Our slightly profitable trade is now just at breakeven! If IV crushes more substantially, then we will see
a further deterioration in results in the trade even though the move in the underlying equity is substantial. The way this trade truly makes money is when
the shares move to a much larger degree than the options market is reflecting in the pricing of premiums ahead of the event.
What’s the bottom line? It is critical that option traders understand the price inputs for premiums in the instruments they are utilizing for trades.
Thorough knowledge of the greeks will assist traders in placing appropriate trades at appropriate times. Earnings season can provide a treasure trove of
opportunity as long as these impacts are well understood. At OptionsAnimal , we provide the knowledge to trade earnings season successfully time and time
again either through protecting invested capital in shares or in creating trades like the straddle/strangle to take advantage of these opportune moments.