Size Up Option Straddles for a Reading on Earnings Volatility

Stock traders can use options pricing to sniff out how much an underlying stock might move around the company’s earnings releases—often shake-rattle-and-roll time for stocks.

This peek at options activity can offer an indication of the time frame you may need to act in if you’re interested in taking part in a potential big move for the stock, especially for so-called momentum stocks. Momentum stocks are listings that a trader believes to be in a clear trend—and once the trend is established, it’s seen as likely (but not guaranteed) to continue in that direction. Momentum stocks sometimes move absent any real news, but they can be particularly sensitive at earnings time.

There are a couple of ways to crunch a stock’s potential price-move range immediately leading up to and just after the release of revenue and profit figures each quarter. The first way is to track options trades known as straddles. Of course, an option trader might pull the trigger on the actual straddle if she has an opinion that the stock will make a big move. But, baby steps. For our purposes here, we’re introducing straddles as a way to watch what others are doing. That, in turn, may help you form an opinion about the stock.

Options Observation Deck

With a long straddle, the investor holds a position in both a call and put with the same strike price and expiration date. Straddles might make sense if an investor believes a stock's price will move significantly but is unsure of the direction. That’s an important distinction for stock investors who are simply curious about options activity. The straddle gives an indication of the total move for the stock. We’re talking about a move in either direction—sometimes even both directions following the report if a stock is particularly volatile. Keep in mind that the straddle “indicator” tends to carry better accuracy odds when applied to liquid stocks moving on strong volume.

The straddle pulls in expectations for implied volatility in the stock, and in this case—an earnings release—we’re talking about implied volatility around one event. A thumbnail way of calculating the expected move of a stock is to use approximately 85% of the front-month straddle. 

Now, it’s true that time decay (the ratio of change of the option's price to the decrease in time to expiration, also known as theta) will reduce the usefulness of this calculation if your view is stretched much beyond this very short-term earnings window.

Our little 101 class on straddles shows you the long-hand way to crunch the options market position on a given pre-earnings stock. There’s another way. TD Ameritrade’s thinkorswim^® platform has a tool that does the mathematical heavy lifting.

Example Time

Have a look at the Ralph Lauren (RL) May 5 action in figure 1, grabbed from TD Ameritrade’s thinkorswim platform. The stock was trading at $135.95 that day. In this image, the earnings implied move is plus or minus $7.651, or just about 5.6%. That means the “options market” is expecting about a 5.6% move in the underlying shares in either direction. 

TD Ameritrade’s Market Maker Move, or MMM*, is essentially the sum of the premium of the ATM puts and calls and is the amount of the move expected up or down from the closing price; it’s accounting for the “extra” volatility that’s likely priced in around this one-off event. MMM is a starting point for your consideration. Any stock chart view that doesn’t include the MMM button means that it’s probable the security is not showing an MMM value at that time.