This article is brought to you by LearningMarkets.com.
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, then the straddle will 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 the case study from the last article, we illustrated a straddle on Google (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 breakeven.
Calculating the expiration breakeven 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 problems selling to exit the straddle and move 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. (You can learn more about trading straddles over the long term here.)
Additionally, more risk tolerant traders may flip the traditional long straddle into a short position that will profit from the deflation in option prices following big announcements. (You can learn more about short straddles here.)
This article originally appeared on the Learning Markets Web site.