Using Earnings Surprises for Straddle and Strangle Buying...
Introduction:
Have you ever bought an investment or stock and had it immediately go against you? In my family it has almost become a joke to suggest taking the other side of every transaction. That way we will be hedged in the short term and once I get stopped out the other side of the transaction will make us a fortune. Fortunately my family has not had to take those steps. A solution to this dilemma is the use of strategies, such as the straddle options strategy, which are independent of the direction of the market. Long straddles and long strangles are two strategies, which are successful if the underlying security goes up or down. Both of these strategies use the purchase of both a PUT and a CALL so a profit can be made for either the PUT or the CALL if the movement of the stock in one direction is large enough.
Straddle Options Strategy Basics:
A straddle is the purchase of both a PUT and a CALL at the same strike price. As an example, the stock of IBM closed at $97.59 on 1/08/2008, buying a put and a call for the $95 or $100 strikes for the month of April could form a straddle. The positions would look like:
| Date |
01/08/2008 |
OR |
Date |
01/08/2008 |
| Stock |
IBM |
Stock |
IBM |
| Stock Price |
$97.59 |
Stock Price |
$97.59 |
| April 95 Call |
$8.30 |
April 100 Call |
$5.70 |
| April 95 Put |
$5.20 |
April 100 Put |
$7.60 |
| Total Debit |
$13.50 |
Total Debit |
$13.30 |
If the stock goes up in price the call will also rise in price, but the put will decrease in price. An important point in an investment position of this type is that the prices of put and call move in opposite directions. Therefore, the movement must be large enough for either the put or the call to dominate and create a profit. As one of the options approaches zero the other option will dominate and continue to increase in price.
The cost of the two options for the 100 strike position is $5.70 + $7.60 or $13.30. By April the stock has to move more than $13.30 to be profitable at expiration. The break-even point on the upside is:
Break Even = Stock Price + Cost = $97.59+ $13.30 = $110.89
And on the down side the break even is:
Break Even = Stock Price - Cost = $97.59 - $13.30 = $84.29
In the short term, stock movements of less than $13.30 can be profitable. On January 18, 2008, IBM's announcement was considered positive and caused its stock price to increase. Several days after an earnings announcement the position was priced at:
| Date |
01/14/2008 |
OR |
Date |
01/14/2008 |
| Stock |
IBM |
Stock |
IBM |
| Stock Price |
$102.93 |
Stock Price |
$102.93 |
| April 95 Call |
$11.50 |
April 100 Call |
$8.20 |
| April 95 Put |
$3.00 |
April 100 Put |
$4.60 |
| Total Debit |
$14.50 |
Total Debit |
$12.80 |
Notice that there was more than a 5-point difference in IBM between these 2 dates as a result of the earnings announcement and yet the Net Debit is actually lower for the 100 strike. Part of this decrease in net debit is due to the bid / ask spread, however, the 95 strike had a very nice increase in value even though the move was not the entire $13.30 required by expiration date. There are several observations that can be made from this straddle options strategy example:
- High priced stocks like this that move around the strike price do not create any speculative opportunity.
- The volatility of IBM is only about 0.30, which is on the low side. It is better for a straddle or strangles strategy to use higher volatility stocks, which have higher price movement.
- It is best to initiate the straddle at the money. In this case if the position was initiated on 1/8/08 @ $97.59, the positive news on 1/14/08 moved the stock to $102.93, but the 100 strike straddle remained unchanged. The gains on the call side were lost on the put side with no net with a loss due to the bid/ask spread.
- The call-biased trade using the 95 strike had a very nice move.
Let's take a look at another straddle options strategy case, which moved in the other direction. On 1/14/08, Intel was expected to announce its earnings in a few days. At the close on 1/14/08 the following straddle position could have been made with the closest strike to the stock price, using 22.5 strike price, giving the position a positive bias since the call price is higher than the put price. An alternative straddle position is to use the 25 strike giving the position a negative bias. The two alternatives are shown below:
| Date |
01/14/2008 |
OR |
Date |
01/14/2008 |
| Stock |
Intel Corp. (INTC) |
Stock |
Intel Corp. (INTC) |
| Stock Price |
$23.08 |
Stock Price |
$23.08 |
| April 22.5 Call |
$2.27 |
April 25 Call |
$1.15 |
| April 22.5 Put |
$1.57 |
April 25 Put |
$2.95 |
| Total Debit |
$3.84 |
Total Debit |
$4.10 |
Earnings were scheduled to be announced after the close on 1/15/08. It was not clear if earnings announcement was going to be positive or negative. The straddle options strategy position was established to take advantage of a surprise in either direction. At the time, Intel also a volatility of about 0.6, which could help create a large move with a surprise in the earning results. After the close on 1/17/08 the following conditions existed:
| Date |
01/17/2008 |
OR |
Date |
01/17/2008 |
| Stock |
Intel Corp. (INTC) |
Stock |
Intel Corp. (INTC) |
| Stock Price |
$19.33 |
Stock Price |
$19.33 |
| April 22.5 Call |
$0.55 |
April 25 Call |
$0.22 |
| April 22.5 Put |
$3.60 |
April 25 Put |
$5.80 |
| Total Debit |
$4.15 |
Total Debit |
$6.02 |
Following Intel's announcement, which was viewed negatively, the April straddles would have produced the following returns:
| 22.5 Strike |
25.0 Strike |
| Return = ( 4.15 - 3.84 ) / 3.84 |
Return = ( 6.02 - 4.10 ) / 4.10 |
| Return = 7.56 % |
Return = 46.83 % |
This was over a three-day span of time. Also note the put biased straddle did much better even though initially it was a little more expensive. In either case we would have waited a few days to exit the position since the stock continued to decline without any sign of retrace. And once the straddle position is nicely in the money (ITM) its price will start to track the stock price very closely. As an example the net debit on the position continued to improve in the days following the announcement:
| Date |
Stock Price |
22.50 Net Debit |
25.00 Net Debit |
| 1/17/2008 |
$19.33 |
$4.15 |
$6.02 |
| 1/18/2008 |
$19.00 |
$4.27 |
$6.27 |
| 1/22/2008 |
$18.63 |
$4.48 |
$6.57 |
If the trend continues, hold on for a week or two, but don't hang around too long. Generally, it is not a good idea to hold a straddle into the month of expiration where the time value will decrease very rapidly. If a position does not have the earnings reaction we expected, it is best to exit the as soon as possible in order to avoid erosion of time premium. It is important to get out quickly as soon as the move is over. Several approaches can be used to determine the exit point:
- Exit if there is no reaction in several days after the announcement.
- Exit if a trend line is violated in the direction of the move.
- Exit if there is a 50% retrace of the stock price.
- Exit if no further movement and it is 2 weeks after the announcement.
Summary of the Straddle Earnings Strategy:
Based on the above discussion, the following conditions would be sought to identify good candidates for a surprise in earning:
- For the straddle to be most effective, it is best to buy strikes at the money. In this way there is no bias for the stock to go up or down and the position is generally less expensive.
- For the strangle it is best when the price of the stock is half way between the 2 strike prices.
- The optimum stock price range should be $20 to $60 per share.
- Need at least 3 months to expiration time to avoid the rapid decay of time value in the option premiums during the last 6 weeks before expiration.
- The straddle for an earnings surprise should be purchased about 2 weeks before the announcement and there should be no pre-announced news, which would discount any stock reaction.
- Positions should be closed about 2 weeks after the earnings announcement with a total holding time of generally one month. The position is held as long as the trend remains intact.
- Under no circumstances should the position be held into the month of expiration.
- Stocks chosen for this strategy should be capable of 5-point moves in one month.
Using PowerOptions for the Straddle Earnings Strategy:
So if you want to be right most of the time, when a large move occurs, the straddle will put you on both sides of the market. And large moves can provide a nice profit. Now you just need to find the stocks that meet the above conditions for a good straddle and this is where PowerOptions can help. Some of the tools available on PowerOptions search engine, which searches the entire market looking for criteria that support finding earnings surprise opportunities are:
- Next earnings date
- Implied volatility of either or both the call and put
- Activity on the option as measured by contracts traded or open interest
- Stock price range to be considered
- Targeted expiration date for the options of interest
- Portfolio tracking of both paper and real trades
- Ability to select strike prices relative to stock price
- The probability is calculated for the stock price to create a profitable trade
Values can be set for any or all of the above parameters to screen for opportunities. There is also a set of "sample screening" criteria set up in both the straddles and strangles tabs that support this type of an earnings surprise strategy.
