If a stock’s going to make a move—perhaps because of an earnings announcement or other upcoming event—then why not consider buying a call option in case it goes up and a put option in case it goes down? This option strategy is known as a long straddle, and the idea is to make a profit without picking a direction.
It might sound like a rational plan. But there’s a little more to consider.
How to Profit from a Long Straddle
Again, the idea of a long straddle is to profit without picking a direction. The position is created by buying an at-the-money call and put in the same expiration. And there are a couple of different ways this strategy can grab a potential profit.
The first is by the stock’s movement. If the underlying moves higher, the call can profit by more than the put option loses, potentially netting a profit after transaction costs. Conversely, the put option can outperform the losses from the call if the stock drops far enough before expiration.
But it’s not just a matter of the stock moving. The stock has to move enough to overcome the losses from the non-performing option, the transaction fees, and time decay, or theta, on both options as well.
Another way straddles can profit is if there’s a rise in implied volatility. Higher implied vol can increase both call and put option prices, but again, it has to be a big enough difference to offset the daily theta subtracted from both options. Volatility, as you’ll see, can play a major role in the profitability, or not, of straddles.
Earnings announcements, or other known events like the introduction of a new product or ruling on a court case, are the kinds of events around which a straddle can be planned. But remember, it’s not the potential event-inspired movement that’s the key here. It’s the potential movement and potential rise in implied volatility leading up to the event that straddle traders are looking for.
Beware the Vol Crush Post-Event
Holding on to a straddle after an event is past can be risky, as the example of FAHN in figure 1 shows. Because volatility plays a big part in a straddle, it’s imperative that the straddle is bought at a time when vol is in the low end of its historical range. In this case, holding a straddle after FAHN’s earnings announcements (highlighted in figure 1 by the red phone icons) could have been risky. Notice how volatility in the lower pane of the graph rose going into the earnings announcements. But the next day, vol crashed back down to its long-term average.
As time passes and an event like earnings gets closer, it’s not unusual to see volatility rise. However, remember that volatility going up doesn’t guarantee a profit, because the straddle is battling time decay each day as the event nears. If the rise in implied volatility offsets theta, then there’s a chance of profiting on movement before the event without time decay becoming an issue. But this is all predicated on buying a straddle when volatility is low, near the lower end of its historical range. As the earnings release approaches, any volatility increase helps offset time decay, and the long straddle position can profit from a move in the underlying.
Let’s take another look at FAHN in figure 2. Notice what happened one day before earnings: volatility jumped, while the stock trended lower. The rise in volatility, combined with the drop in the stock, likely resulted in a potential profit for a long straddle purchased about 30 days before.
Don’t give in to the temptation to hold a straddle into an earnings announcement (or whatever other event a long straddle might be based on). Volatility is likely to come crashing back down toward its historical level after the event, putting the straddle at risk of losing a lot of value. Remember, this options trade is based on the possibility of a volatility jump and stock movement prior to the announcement or event.
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