The earnings season provides a lot of opportunities for active options traders. Some traders like to play earnings with directional bets, buying straight calls or puts. This is a very tough strategy. You have too many factors playing against you. Even if you are correct about direction, you need to overcome the Implied Volatility (IV) collapse that usually comes after earnings are announced.
Personally, I prefer to play earnings non-directionally. One of my favorite strategies is buying a straddle (or a strangle) few days before earnings.
How straddles make or lose money
A straddle is vega positive, gamma positive and theta negative trade. That means that all other factors equal, the straddle will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle to make money, one of the two things (or both) has to happen:
1. The stock has to move (no matter which direction).
2. The IV (Implied Volatility) has to increase.
A straddle works based on the premise that both call and put options have unlimited profit potential but limited loss. While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be close before expiration for a profit.
In many cases IV increase can also produce nice gains since both options will increase in value as a result from increased IV.
Why earnings straddle?
IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. Under normal conditions, a straddle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings straddle, the negative theta is neutralized, at least partially, by increasing IV. In some cases, the theta is larger than the IV increase and the trade is a loser. However, the losses in most cases are relatively small. Typical loss is around 10-12%, in some rare cases it might reach 20-25%. But the winners far outpace the losers and the strategy is overall profitable.
How straddles can serve as a cheap black swan insurance
I like to trade pre-earnings straddles/strangles for several reasons.
First, the risk/reward is very appealing. Basically, there are three possible scenarios:
- The IV increase is not enough to offset the negative theta and the stock doesn’t move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.
- The IV increase offsets the negative theta and the stock doesn’t move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
- The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners. For example, when Google moved 7% in the first few day of July 2011, a strangle produced a 178% gain. In the same cycle, Apple’s 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had the Disney (DIS) strangle and few other trades doubled in a matter of two days.
During decent corrections, you can have very nice gains, as a result of both stock movement and IV increase.
Profit Target and Stop Loss
My typical profit target on straddles is 10-15%. I might increase it in more volatile markets. I usually don’t set a stop loss on a straddle. The reason is that the upcoming earnings will usually set a floor under the price of the straddle. Typically those trade don’t lose more than 5-10%.
The biggest risk of those trades is pre-announcement. If a company pre-announces earnings before the planned date, the IV of the options will collapse and the straddle can be a big loser. However, pre-announcement usually means that the results will be not as expected, which in most cases causes the stock to move. So most of the time, the loss will not be too high, especially if there is still more than two weeks to expiration. But this is a risk that needs to be considered.
As a general rule, I don’t hold those trades through earnings. Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
Summary
Earnings straddle can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without the need to guess the direction.
Kim Klaiman is a full time options trader and has been trading stocks and options for more than 10 years. Kim is a founder of educational blog and forum steadyoptions.com. He likes to trade a variety of non-directional trades with low correlation to limit the total portfolio risk.
Kim Klaiman
Founder and Editor
