Top 3 Tips On Buying A Straddle For Earnings
Reliable opportunities for big profits can be tough to come by but if you play your cards right and do your homework you can find some excellent opportunities during earning season.
One play we really like is the long straddle, which involves buying an at the money call and put. There are a couple of different ways to play this trade so read on to find out why this trade can be a reliable source of profits during earning season!
The Long Straddle
A long straddle is a simple yet sophisticated options position that involves buying both at the money call and put, where the strike price of both options is close to the current stock price, with the same expiration date, usually going past the earnings date.
The theory behind the long straddle is that the buyer of the position expects a high degree of volatility after the company releases earnings, but they are unsure in which direction the price will change.
The long straddle provides positive exposure to a significant price move in either direction, with a chance to profit as long as the price change is large enough to cover the premiums regardless of the direction of the change.
With this strategy you have two break even spots with the first one being the strike price plus the net debit paid and the other being the strike price minus the net debit paid.
So for example, if you bought a long straddle on Netflix with a strike price of $195 for a net debit of $17.45 ($1,745 total cost) then your breakeven points would be $212.45 and $177.55. You would need the stock to move above or below those prices in order to be profitable but keep in mind that theta (time decay) and implied volatility will affect prices before earnings are announced.
In theory you have unlimited profit potential because the stock can keep going up, but we know that’s never the case. The main goal behind this strategy is to capture a large move in either direction or let implied volatility juice up premiums which I will go over more below.
Stocks With High Volatility On Earnings Reports
The straddle before an earnings report trade works best when used with stocks that have a reliable history of significant price movements after an earnings report. These are usually big name stocks with large market caps, high trading volumes and variable business models.
Think of companies such as Amazon, Apple and Netflix. These companies all have volatile earnings with price movements regularly reaching more than 5% up/down post earnings. These volatile names usually build up anticipation and with that comes high implied volatility. Implied volatility is a key metric in pricing options so when that spikes up like it typically does before earnings we can also see a hefty rise in option premiums even if the stock doesn’t move much!
In the implied volatility chart above you can how the yellow line spikes and then plummets. Can you guess what is causing that? Thats right! Earnings. This spikes in implied volatility help juice up premiums which means you could potentially take profits without even holding through earnings.
Buy Your Straddle Early
The price of an option is in large part a product of the expected volatility of the underlying stock’s price. The nearer that you get to the earnings report, the higher the price of the options in your straddle will become because of implied volatility. Therefore, it is best to buy your options 2 to 3 weeks or even more before the earnings report, so that you can avoid the increase in premium that occurs as the date approaches.
You also pay more for longer dated options, so you do not want to buy them too early or or you will pay a higher premium for the duration effect of the options without any price advantage on the volatility effect.
Learning how to balance the volatility and duration effects when selecting options for your derivatives trades is one of the essential skills to successful derivatives trading, so spending some time working on this will not be wasted.
A Great Entry Level Derivatives Trade
The long straddle on an earnings report is a great entry level derivatives trade for exposing new derivatives traders to the concepts, technical aspects and underlying theory involved in successful derivatives trading. Derivatives allow you to create highly sophisticated positions and to make trades that would otherwise be impossible or much less reliable using more traditional trading techniques.
Once you have successfully accomplished a few long straddle on an earnings report trades, you will be ready to graduate to more complex and nuanced derivatives trades with the knowledge and confidence to succeed.
As we near some big earning dates for companies like Netflix, Facebook and Amazon it is important to plan your trade out carefully and get a good price on your options. It’s always a good idea to look at implied volatility charts to make sure you aren’t over paying which you usually won’t be if you buy them two to three weeks in advance.
Another important thing to keep in mind while playing earning straddle’s is that even though you can make a substantial amount if the stock makes a huge move following earnings, it is far more reliable to buy two to three weeks before earnings and let implied volatility juice up the premiums. Then you could collect profits before earnings and not risk getting burned because even if the stock makes a big move, if it isn’t enough the premium in the options will be sucked out as implied volatility plummets.
Let us know if you have any questions in the comments below!