As a general rule, the value of any stock ultimately reflects the trend, or expected trend, of the earnings of the underlying company. In other words, firms that grow their earnings consistently are likely to rise over time greater than the stocks of firms with erratic earnings or losses. This is the reason so many investors pay close attention to earnings announcements.

Every quarter, publicly held U.S. firms are required by the Securities and Exchange Commission (SEC) to announce their latest earnings and sales results. Sometimes, nevertheless, an organization releases an earnings surprise, and the stock market reacts in a decisive fashion. Sometimes, the reported results are significantly better than expected—a positive earnings surprise—and the stock reacts by advancing sharply in a really short time frame to bring the value of the stock back according to its recent and improved status.

Likewise, if an organization proclaims earnings and/or sales which might be far worse than anticipated—a negative earnings surprise—this can lead to a pointy, sudden decline in the value of the stock, as investors dump the shares in an effort to avoid holding onto an organization now perceived to be “damaged goods”.

Either scenario can offer a potentially profitable trading opportunity via the usage of an option trading strategy often known as the long straddle. Let’s take a more in-depth have a look at this strategy in motion.

The Mechanics of the Long Straddle

A protracted straddle simply involves buying a call option and a put option with the identical strike price and the identical expiration month. With a purpose to use an extended straddle to play an earnings announcement, you need to first determine when earnings will likely be announced for a given stock.

You may additionally analyze the history of the stock itself to find out whether it is usually a volatile stock and if it has previously had large reactions to earnings announcements. The more volatile the stock and the more prone it’s to react strongly to an earnings announcement, the higher. Assuming you discover a professional stock, the subsequent step is to find out when the subsequent earnings announcement is due for that company and to ascertain an extended straddle before earnings are announced.

Setting Up the Long Straddle Position

When to Enter

When organising the long straddle, the primary query to contemplate is when to enter the trade. Some traders will enter right into a straddle 4 to 6 weeks prior to an earnings announcement with the concept there could also be some price movement in anticipation of the upcoming announcement.

Others will wait until about two weeks prior to the announcement. In any event, it’s best to generally look to ascertain an extended straddle prior to the week before the earnings announcement. It’s because very often, the period of time premium built into the value of the choices for a stock with an impending earnings announcement will rise just prior to the announcement, because the market anticipates the potential for increased volatility once earnings are announced.

Because of this, options may often be inexpensive (by way of the period of time premium built into the choice prices) two to 6 weeks prior to an earnings announcement than they’re in the previous few days prior to the announcement itself.

Which Strike Price to Use

When it comes to deciding which particular options to purchase, there are several selections and a pair of choices to be made. The primary query here is which strike price to make use of. Typically, it’s best to buy the straddle that is taken into account to be at the cash. So, if the value of the underlying stock is $51 a share, you’ll buy the 50 strike price call and the 50 strike price put. If the stock was as a substitute trading at $54 a share, you’ll buy the 55 strike price call and the 55 strike price put. If the stock was trading at $52.50 a share, you’ll select either the 50 straddle or the 55 straddle (the 50 straddle can be preferable if by probability you had an upside bias and the 55 straddle can be preferable in case you had a downside bias).

One other alternative can be to enter into what’s often known as a strangle by buying the 55 strike price call option and the 50 strike price put option. Like a straddle, a strangle involves the simultaneous purchase of a call and put option. The difference is that with a strangle, you purchase a call and a put with different strike prices.

Which Expiration Month to Trade

The subsequent decision to be made is which expiration month to trade. There are typically different expiration months available. The goal is to purchase enough time for the stock to maneuver far enough to generate a profit on the straddle without spending an excessive amount of money. The final word goal in buying a straddle prior to an earnings announcement is for the stock to react to the announcement strongly and quickly, thus allowing the straddle trader to take a fast profit. The second-best scenario is for the stock to launch into a robust trend following the earnings announcement. Nonetheless, this might require that you simply give the trade at the least somewhat little bit of time to work out.

Shorter-term options cost less because they’ve less time premium built into them than longer-term options. Nonetheless, in addition they will experience an awesome deal more time decay (the period of time premium lost every day due solely to the passage of time) and this limits the period of time which you can hold the trade. Typically, it’s best to not hold a straddle with options which have lower than 30 days left until expiration because time decay tends to speed up within the last month prior to expiration. Likewise, it is sensible to provide yourself at the least two or three weeks of time after the earnings announcement for the stock to maneuver without moving into the last 30 days prior to expiration.

For instance, as an example that you simply plan to execute a straddle contract two weeks—or 14 days—prior to an earnings announcement. Let’s also say that you simply plan to provide the trade two weeks—or one other 14 days—after the announcement to work out. Lastly, let’s assume that you simply don’t want to carry the straddle if there are fewer than 30 days left until expiration. If we add 14 days before plus 14 days after plus 30 days prior to expiration we get a complete of 58 days. So on this case, it’s best to search for the expiration month that has a minimum of 58 days left until expiration.

Example Trade

Let’s consider a real-world example. Apollo Group (Nasdaq: APOL) was attributable to announce earnings after the close of trading on March 27, 2008. On Feb. 26, a trader might need considered buying an extended straddle or an extended strangle in an effort to be positioned if the stock reacted strongly someway to the earnings announcement. On this case, APOL was trading at $65.60 a share.

A trader could have bought one contract each of the May 70 call at $5 and the May 60 put at $4.40. The overall cost to enter this trade can be the price of the 2 premiums, or $940 (($5 + $4.40) x 100)). Each option contract consists of 100 shares of the underlying stock. This represents the entire risk on the trade. Nonetheless, the likelihood of experiencing the utmost loss is nil because this trade will likely be exited shortly after the earnings announcement and thus well before the May options expire.

In case you have a look at Figure 1, you will note the value motion of APOL through February 26 on the left and the “risk curves” for the May 70-60 strangle on the precise. The second line from the precise represents the expected profit or loss from this trade as of a number of days prior to earnings. At this time limit, the worst-case scenario if the stock is unchanged is a loss of roughly $250.

Figure 1: Apollo Group stock and risk curves Source: ProfitSource

On March 27, APOL closed at $56.34 a share. After the close on March 27, APOL announced disappointing earnings. The next day, the stock opened at $44.38 and closed at $41.21. As you may see in Figure 2, at this point, the May 70-60 strangle showed an open profit of $945.

Figure 2: Apollo gaps lower after earnings announcement; strangle shows big profit Source: ProfitSource

So, in this instance, the trader could have exited the trade sooner or later after the earnings announcement and booked a 100% profit on investment.

The Bottom Line

Within the old days, an investor or trader would analyze the prospects for the earnings of a given company and, based on that evaluation, would either buy the stock (if he thought the earnings would grow) or stand aside (if he thought the earnings can be disappointing). With option trading, a trader or investor can now play an earnings announcement without having to take a side. So long as a trader has some reason to expect an earnings surprise or a stock simply has a history of reacting strongly to earnings announcements, they will use an extended straddle or strangle to benefit from the anticipated price movement.

If the stock does indeed make a pointy price movement—in either direction—a large profit is feasible. As well as, if the trade is correctly positioned (i.e., with enough time left until expiration) and properly managed (i.e., exited reasonably soon after the earnings announcement), then the chance on the trade is usually quite small. In sum, this strategy represents another strategy to use options to benefit from unique opportunities within the stock market.

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