2 Ways to Trade Options to Bet On Earnings Volatility

Options can provide an ideal way to trade volatile earnings season with less capital on the line

Apr 20, 2017 at 2:25 PM
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    Earnings season is upon us. While it may seem like a scary time to trade stocks given the heightened chance of a volatile post-earnings move, options can often provide speculative players the ability to invest in the stock market, but with less capital on the line than buying or shorting shares outright. While the purchase of straight calls and puts are an appealing choice for rookie traders, more seasoned players may want to try their hand at a long straddle or long strangle during earnings season -- which allows options traders to profit on a big move in the underlying equity, regardless of direction.

    How to Initiate a Long Straddle

    A long straddle is created when an options trader buys to open an at-the-money call and put with the same strike and expiration date. While the purchase of both legs increases the cost of the position, it also allows the trader to profit on a big move in either direction.

    To see this strategy in action, imagine stock XYZ is trading near $20 ahead of its May 1 earnings report, and the shares have a history of swinging wildly after earnings. To initiate a long straddle on XYZ, an options trader would buy a May 20 call for $1.20 and a May 20 put for $0.70, creating an initial cash outlay of $190 per spread [($1.20 call premium + $0.70 put premium) * 100 shares].

    Given that there are two legs to the trade, the two breakeven points are $18.10 (strike less the net debit) and $21.90 (strike plus the net debit), meaning the options trader will profit should the stock swing south of the lower rail or north of the upper rail within the options' lifetime. Profit is theoretically unlimited to the upside, while limited to $18.10 (put strike less net debit) on a move down to zero. Risk is capped at the initial cash outlay, should XYZ stay stagnant through expiration.

    Why Play a Long Strangle

    A long strangle is similar to the straddle, only the call and put have different strikes. By splitting the strikes, the cost of entry will theoretically be reduced, since the options will be out of the money. However, profiting requires a much bigger move by the stock, typically, regardless of direction.

    Using the same example from above, with stock XYZ trading near $20 ahead of its upcoming earnings report, an options trader would buy to open a May 21 call for $0.60 and a May 19 put for $0.45, creating an initial net debit of $1.05 per pair of options. Accounting for 100 shares per contract, this equates to an initial cash outlay of $105 for the long strangle.

    The upper breakeven level for the trade is $22.05 (call strike plus net debit), while the lower breakeven rail is $17.95 (put strike less net debit). As with the long straddle, profit on the strangle is theoretically unlimited to the upside, and capped at $17.95 to the downside. Should stock XYZ stay within the two strikes through expiration, the most the options trader stands to lose is the initial cash outlay.

    25 Options Trading Ideas for This Earnings Season

    Considering both of these strategies require a trader to pay "double premium" by purchasing both the call and the put, it's important to take into account implied volatility (IV) -- one of the main factors in determining an options' price. Low IV roughly translates to lower-cost options -- a boon to premium buyers -- while higher IV indicates relatively rich premiums, a benefit to option sellers.

    Below is a list of 25 stocks complied by Schaeffer's Senior Quantitative Analyst Rocky White that trade at least one million shares per day and have closed at $7 or more, and could be ideal candidates for long straddle or strangle this earnings season. Specifically, these stocks have the highest Schaeffer's Volatility Scorecard (SVS) readings, meaning they have tended to make outsized moves on the charts in the past year, relative to what the options market has priced in. Additionally, stocks with a low Schaeffer's Volatility Index (SVI) percentile rank have near-term options that are pricing in relatively low volatility expectations at the moment -- an added bonus to premium buyers.

    stocks with prime trading opportunities

    *Earnings dates subject to change

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