As another earnings season begins, options traders are presented with an opportunity to structure trades that aim to take advantage of the potentially explosive moves in stock prices that can occur with the release of earnings information and forward guidance. While it is often difficult to predict the direction a stock may take after an earnings release, there are trades that are agnostic about the direction a stock moves and can potentially profit from moves in either direction. One such trade is the straddle options strategy.
The straddle trade utilizes both long calls and long puts to make money when the underlying stock undergoes significant price change. The structure of the trade is quite simple; however, there are several potential pitfalls with this strategy. Let’s first look at the structure of the trade and then examine some problems it can pose.
In order to establish a straddle position, the trader purchases a long call option and long put option at the money – at or near the price at which the equity is trading. It may seem counterintuitive to purchase both a bullish and a bearish option on the same equity, however, when purchasing a straddle the trader does not care if the underlying moves up or down. She simply needs it to move.
As a debit trade, the straddle has a defined risk equal to the debit paid to enter the position. The potential reward is theoretically unlimited to the upside and equals the strike price of the long put minus the debit paid for the entire trade. After all, stocks cannot trade below zero. The breakeven points are easily calculated. To the downside subtract the debit of the trade from the strike price of the options. To the upside add the cost of the trade to the strike price of the options.
With an explosive move up the value of the long call option will rise in value and if successful, the gains in the call will overcome the cost of the trade and generate profits. It works the same way to the downside with the profit in the put side overcoming the cost of the trade. Sounds simple. After all, stocks gap up and down with regularity after earnings and other fundamental events. Be careful though, generating profits with this trade is harder than it looks for several reasons and the trader must consider several factors before entering a straddle.
Since we are purchasing both a long call option and a long put option this trade can be quite expensive. Because we are long both a call and a put the trade is theta negative. This means that without movement in the underlying the trade will lose value with each passing day.
To avoid this possibility it might be tempting to purchase the straddle immediately before the event. However, if we wait until the day before the event to enter the straddle we are likely purchasing the options when implied volatility is highest and the options are most expensive. Since volatility will drop dramatically after the event this vega positive trade will suffer from the decrease in volatility.
Finally, it is important to realize that the price of the options we are purchasing reflects the markets predicted move in the underlying stock. If this is unclear to you I suggest you read this blog post by Eric Hale. In short, in order for our straddle to work the underlying must move more than what the market predicts.
So how can we increase the odds of making a profit with the straddle trade? Ideally, we would enter the trade prior to the expected increase in implied volatility. We could also choose to purchase options that expire well after the event in order to allow ourselves the opportunity to adjust the trade by selling options against our longs to recoup some or all of our potential losses should the trade fail to perform as we planned.
In addition to giving us a chance to adjust the trade if the stock does not move after the event, longer dated options will decay at a slower rate than near term options. Finally, entering the trade before IV rises the trade stands to benefit from an increase in volatility.
In addition to carefully considering our entry into the trade and the expiration series of the contracts we are purchasing, it would be wise to look for equities that have a history of moving more than the predicted move over events in the past. This selection process involves looking back over past events to find potential candidates for the trade.
Although the potential rewards of the straddle trade are large, I am not inclined to enter these positions very often for all the reasons outlined above. If you do wish to use straddles make sure you understand the implied volatility and how it will impact your trade. Do the work to find potential candidate equities, and be prepared to make adjustments to the trade when necessary.