Can straddles be used in an options strategy around earnings announcements or other market-moving events? Yes, but there are risks and other considerations.
Some traders think a stock’s going to make a move, perhaps because of an earnings announcement or other upcoming event, then they consider buying a call option in case it goes up and a put option in case it goes down. This options strategy is known as a long straddle, and the idea is for the underlying to make a large move in either direction, so the straddle price expands beyond what was paid for it.
It might sound like a rational plan. But there’s a little more to consider.
Again, the idea of a long straddle is to gain from a large move without picking a direction. The position is created by buying an at-the-money (ATM) call and ATM put with the same strike price in the same expiration cycle. There are a couple different ways this strategy might see gains.
First, the long straddle could profit if the underlying stock moves significantly. If it moves higher, the call option may profit by more than the put option loses, potentially netting a profit after transaction costs. Conversely, the put option may outperform the losses from the call if the stock drops far enough before expiration.
It’s not just a matter of the stock moving, but also the magnitude of the stock’s movement. It needs to move far enough to overcome the price paid for the straddle, in addition to the transaction costs.
Another way long straddles can profit is if there’s a rise in implied volatility (vol). Higher implied vol can increase both call and put options prices, just as lower vol can decrease both the put and call prices (which would typically lead to a loss). Even if vol were to stay the same, the trade can lose, as option prices tend to decay with the passage of time.
So even if there is a rise in implied vol, it has to be a big enough difference to offset the time decay (“theta”) subtracted from both options. Vol and time decay, as we’ll see, can play a major role in whether a straddle is a winner or a loser.
Earnings announcements, or other known events (such as the introduction of a new product or ruling on a court case) are the types of events in which a long straddle trade might be placed. What’s important to keep in mind is that the straddle is pricing in the “normal” volatility days plus the heightened “event day volatility.” As you get closer to the event, there are fewer normal vol (lower) days, so the higher event day vol has more influence. This is why the implied vol usually rises leading into the event.
Holding on to a straddle through an event can be risky (see figure 1). Because volatility plays a big part in a straddle, it’s imperative that the straddle is bought at a time when vol is near the low end of its historical range. In figure 1, holding a straddle after the earnings announcements (marked by the red phone icons) could have been problematic if the post earnings move was not large enough to make up for the steep drop in vol. Notice how vol in the lower pane of the graph rose going into the earnings announcement, but regressed to its long term average following the event.
FIGURE 1: VOLATILITY AROUND EARNINGS ANNOUNCEMENTS. Volatility tends to rise ahead of a company’s earnings announcement and then tends to fall after the event has taken place. Data source: Cboe. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
If you feel that the premium levels in the options are elevated enough to make up for a post-event move in the underlying, then selling a straddle ahead of the announcement might make sense. It’s important to remember, though, that selling a straddle entails open-ended risk. The maximum profit is capped at the strike, and it begins to erode the further the underlying moves away from it. Eventually, the profit turns to a loss, with no limitation on the upside. On the downside, the loss is capped only when the underlying stock goes to zero (see the short straddle risk graph below).
One potential alternative is a short iron condor. It’s a four-legged spread constructed by selling one call vertical spread and one put vertical spread simultaneously in the same expiration cycle. Typically, both vertical spreads are out of the money and centered around the current underlying price (see the iron condor risk graph).
The iron condor strategy is a favorite of many option traders as a way to take advantage of higher-than-typical implied vol, such as before an earnings release. Note that, unlike the short straddle, the iron condor’s risk is defined by the difference between the strike prices of the verticals minus the credit received when selling the iron condor. For example, if the verticals are $2 wide and the iron condor is sold for an $0.80 credit, the risk is $1.20 per contract before transaction costs.
The iron condor strategy is typically considered by traders who believe the current vol is elevated, they expect vol to drop once the news is out, and if they believe the price of the underlying will remain between the two short strikes in the iron condor (or at least close). But one reminder about an iron condor: This spread has four legs, which means extra transaction costs.
There’s no right or wrong way to play earnings and other company announcements; much depends on your objectives, risk tolerance, and the your view of the market. Long options straddles can be an effective way to trade the lead-in to earnings, but traders might also consider short options strategies going into the release. Just make sure you know and are comfortable with the risks involved.
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