2 Option Strategies to Profit From Earnings Volatility

The long strangle and straddle are two options strategies that allow traders to profit from a stock's volatility, regardless of direction

by Celeste Taylor

    Published on Oct 13, 2016 at 4:16 PM
    Updated on Oct 14, 2016 at 1:07 PM

    With earnings season ramping up, traders might be looking for a way to cash in on this especially volatile time of the year. However, predicting a stock's post-earnings trajectory can be difficult to do (or else everyone would do it!). For option traders, however, there are strategies that allow you take advantage of big stock moves, regardless of the direction.

    Long Strangle

    The first of these options strategies is the long strangle. In this two-legged approach, a trader purchases one call and one put on the same underlying security, but at different strikes. If the underlying then makes a big enough move -- say, tumbles after an earnings miss, or skyrockets on an earnings win -- the trader will profit.

    For example, say Auto Stock XYZ is set to report earnings at the end of the month. While sector-wise, the auto industry hasn't done well this past quarter, XYZ launched a new electric car, and its upcoming earnings report will have the first round of sales data for the new vehicle. Will XYZ follow its peers into the downward spiral, or will stellar vehicle sales send the stock on a tear upwards?

    In an attempt to take advantage of both potential scenarios, one trader initiates a long strangle in an options series expiring in about a month. Since XYZ is currently trading at $100, the trader buys to open one 97.50-strike put, asked at $4, as well as one 103-strike call, also asked at $4. The total cost to enter this trade is $8, or $800 (x 100 shares), which is also the most the speculator stands to lose.

    If XYZ rallies north of $111 (call strike plus $8 premium paid), or sinks below $89.50 (put strike minus $8 premium paid), within the options' lifetime, the trader will begin to see profits. The worst-case scenario is that XYZ will stick close to $100 and both options will expire worthless, so the $800 premium paid will be lost.

    Long Straddle

    A long straddle is another two-legged approach that allows traders to take advantage of heightened volatility. In a long straddle, a trader simply purchases both a call and put option at the same strike price.

    In this example, the aforementioned trader perhaps bought a call and put at XYZ's 100 strike, for $6 apiece, or $12 a pair -- a sum of $1,200 (x 100 shares). If the stock rallies above $112 (strike plus premium paid) or sinks below $88 (strike minus premium paid) before the options expire in a few weeks, the speculator will begin to profit. Again, if the stock remains relatively stagnant through expiration, the most the trader will lose is the initial premium paid, or in this case, $1,200.

    Straddle vs. Strangle

    For a long strangle, the price of entry -- and, thus, the maximum risk -- is generally lower, since the option player is typically purchasing out-of-the-money options. However, in many situations, long strangles require a larger move in either direction to be profitable. For a long straddle, the cost of entry can be higher, but can require less of a move in either direction to become profitable. This is why option premiums and strike prices are very important when deciding which strategy to implement.

    Putting Theory Into Practice

    The following 25 stocks could exceed option players' post-earnings volatility expectations, if history is any indicator. The list, compiled by Schaeffer's Senior Quantitative Analyst Rocky White, considered all stocks trading at least one million shares per day, and that closed at $7 or more. Each of these 25 stocks are expected to report earnings within the next three weeks, and all have an elevated Schaeffer's Volatility Scorecard (SVS), which indicates the stock has tended to exceed volatility expectations during the past year -- a boon for straddle and strangle traders.

    In addition, the chart also shows each equity's Schaeffer's Volatility Index (SVI) and where it stands in relation to the past years' worth of readings. A high percentage indicates near-term option players are pricing in relatively lofty volatility expectations -- typically indicating historically inflated near-term option premiums -- while a low percentage suggests the options are more attractively priced. 

    High SVS Oct 13_2

    *Earnings dates may be tentative and subject to change


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