Try a Southwestern Energy Straddle Before Earnings

by John Kmiecik | April 25, 2013 9:02 am

Being stuck in the middle of earnings season like we are now, traders need to be a little cautious and understand the ramifications of what an announcement could do to the volatility of the stock. But that doesn’t mean you have to completely ignore trading a stock that has a pending announcement.

Here is a trade idea that looks to capture a move before a company’s report:

Southwestern Energy (NYSE:SWN — $34.97): Long Straddle

The trade: Buy the May 35 call and the May 35 put for $2.25 or less.

The strategy: A straddle is when you buy a call and a put at the same strike price relatively at-the-money. Straddles are volatility spreads. When a straddle is bought, it is done in the expectation of a big move either up or down. In effect, an option trader has an opinion about volatility, but not the price. The maximum profit on a straddle is theoretically unlimited because the stock can continue to rise forever and pretty much fall to zero. The maximum loss is $2.25 or whatever was paid for the straddle if SWN finishes exactly at $35 at May expiration. Both options would expire worthless.

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The rationale: This trade idea makes sense from both a stock volatility standpoint as well as an implied volatility standpoint. SWN is scheduled to release its earnings on May 2 after the close. In the past, Southwestern Energy’s stock has acted very volatile before the announcement … and for this straddle idea to work, that needs to happen again. There also is a very good chance that implied volatility for the long May options might increase before earnings because of the pending announcement. This will help offset some of the premium lost due to theta (time decay) as the options move closer to expiration. During the past several sessions, the stock has declined from $39 to where it’s currently trading. A movement back up or a movement lower would be much appreciated!

This trade idea looks to capture the movement of the stock and the increased volatility as it heads closer to the announcement before the actual announcement. Then it can be exited before the announcement — hopefully for a profit. It is usually not a good idea to hold a straddle over an earnings announcement because implied volatility tends to erode shortly afterward, which hurts a long option position like a straddle.

As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.

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