So, here’s the situation: Earnings are due to come in on a momentum stock like, say, Google (NASDAQ:GOOG), Green Mountain Coffee Roasters (NASDAQ:GMCR), Netflix (NASDAQ:NFLX) or Apple (NASDAQ:AAPL). You think one of these is going to blow away numbers or perhaps they will miss, but you aren’t sure which will happen. Even a slight miss could tank these plays, whereas even a slight beat could send the stock soaring. Holding the underlying stock is mighty dangerous with these babies, which is why options make a perfect solution.
In particular, if you think a big move is coming, then put your hands around the throat of the stock with a long strangle.
A long strangle is when you go long a call option and a put option with the same expiration, but the call strike price is above the put strike price. Typically both options are out-of-the-money, but you can do an in-the-money option if you wish (it’ll just be more expensive).
The idea is that if you are right, and your chosen stock does move big in either direction, you’ll win big on one side of the trade, and only lose what you invested in the other. Your maximum loss would be if the stock really didn’t move at all, in which case you’d only be out what you invested in the options. However, if expiration is far enough away, you should be able to sell those long options for a minor loss. The volatility premium will likely have declined in the interim, so you will likely take a loss, just not the whole thing.
In my case, I recently experienced exactly this scenario with gun manufacturer Sturm, Ruger (NYSE:RGR) when it reported earnings last month. I expected RGR to blow away numbers, but just in case, I purchased a long strangle. It turns out that its numbers were fantastic, but the market must’ve expected this, because the stock didn’t really move. Still, I only lost $160 on the trade.
However, the maximum gain is unlimited. If the stock flies or tanks big time, you profit big time. This happened to me last year when I purchased a long strangle on Green Mountain. The company missed estimates, and the stock fell 15 points the next morning. I cashed in right away for a big gain.
If the stock doesn’t move immediately, or if it moves much less than you anticipated, it is sometimes worth waiting a few more days. Sometimes the market takes a few days to digest certain news.
So let’s look at Google, which reports on April 18; options expiration is on April 20.
Now, I usually suggest waiting to do a long strangle until the day before the earnings event, but let’s see what we have going now so you can see an example.
The stock trades at $808. The April 810 Call is going for $23. The April 805 Put is also going for $23. By investing $4,600, you are now able to play Google in either direction.
Now, your natural response should be, “$4600? Are you crazy? I could buy actual stock for that!” Yes, that’s true, and maybe you should. Again, however, this strategy assumes you have strong convictions that the stock will move strongly in one direction. If you aren’t that convinced, then move on.
Of course, there are cheaper stocks where this strategy can be played.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.