There are plenty of options strategies for traders to consider holding through an earnings announcement, and we will talk about some of those in future posts. But there is also a strategy to consider that is meant to be closed out prior to earnings that most options traders are probably familiar with — buying a straddle or strangle ahead of earnings.
Let’s take a look below what a straddle and strangle is, in case you are not familiar with them.
Keeping it fairly simple, both a straddle and strangle consist of buying both a call and put with the same expiration date and on the same security. A straddle is buying a call and put at the same strike price, and a strangle is buying them for two different strike prices. For the most part, one is chosen over the other based on how close the underlying stock is trading to a particular strike price.
There are different ways in which to profit — either from delta (changes in option premium based on direction), vega (changes in option premium based on volatility) or both.
Since both a call and put are purchased, it is beneficial for the stock to move distinctly in one direction. Then you will have either positive or negative delta and the trade will benefit from a continued move in the direction of the delta.
Up and down action is not beneficial usually.
Vega effects option premium based on the implied volatility. Options increase in price when IV rises and vice versa. Since the position is long a call and put, it is beneficial for IV to increase.
There are several companies that are expected to announce next week, including Netflix, Inc. (NASDAQ:NFLX). But this strategy can work best when there are a couple of weeks left until the expected announcement. Enter Facebook Inc (NASDAQ:FB). The company is expected to announce quarterly earnings on May 3.
Lawrence Meyers just recently wrote about Facebook stock and how he now considers it to be investment-worthy and he notes how digital advertising is being dominated by FB and Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL). Will the stock rise ahead of earnings because of a perceived value or will this uncertain market pull the stock lower after a months-long run higher?
An Option Straddle Idea to Consider on FB Stock
The Rationale: The plan for buying a straddle or strangle based on earnings is to put the position on ahead of earnings and exit the position (hopefully for a profit) before the actual announcement. Of course, the position can be held over the announcement, but a big move is probably needed to profit because the IV will drop — and so will the option premiums — after the announcement.
Although past performance is not indicative of future behavior, it might be beneficial to look at a stock’s previous earnings to gauge if it may be a good candidate. Take a look at a one-year chart of FB stock below. The stock has moved fairly well prior to the announcement several times in the past.
Click to Enlarge The goal is for the stock to move decisively before the actual announcement. Consider buying the position anywhere from about a month to about a week prior to the announcement. Remember time decay (theta) is a concern, so be sure to allow enough time and maybe not just pick the expiration that takes place right after the expected announcement.
What usually benefits this pre-earnings position is vega. Since implied volatility (IV) generally rises as the earnings date nears, option premiums should rise as well minus any time decay. If the stock moves decidedly higher or lower after the position is put on and IV increases, it is a win-win for the position. Consider managing the position for profit based on an expected return goal like a certain percentage. Consider managing the position on the stop-loss side of things based on two criteria: an exit at a certain point (like before the announcement) and/or a certain percentage of risk, just like you may for profit.
The Trade: Buy the May $140 call and the May $140 put for $9 or less.
The Strategy: The maximum profit on a straddle is theoretically unlimited because the stock can continue to rise up until expiration and pretty much fall to zero. The maximum loss is $9, or whatever was paid for the straddle, if FB stock finishes right at $140 at May expiration. Both options would expire worthless. There are two breakeven points at expiration; $131 to the downside and $149 to the upside based on a cost of $9.
John Kmiecik is the head options instructor for Market Taker Mentoring, and co-author of the eBook 3 Secrets to Making Money in Any Market. Get your complimentary copy of his option trading eBook here. He can be reached at john@markettaker.com. At the time of this writing, he did not own a position in any of the aforementioned securities.
