Four Strategies to Make Money This Earnings Season
- Posted by Andrea Kramer
- on April 6th, 2011
Yep, it’s that time of year again — blue-chip behemoth Alcoa Inc. $AA is set report its quarterly earnings on Monday, marking the unofficial start to first-quarter earnings season. As most of you already know, notable events like earnings are often catalysts for significant price swings on the charts. While this type of uncertainty can keep stock traders up at night, there are a number of ways options speculators can toe the bullish/bearish line to profit from a monstrous move in either direction.
The first of a few oddly named strategies we’ll discuss today is the long straddle. In the simplest terms, the long straddle is constructed by buying an equal number of puts and calls at the same strike and within the same series. Typically, straddle strategists will select a strike that’s at or near the money, and will hone in on the expiration month in which the company’s report is scheduled (April, for AA).
In order to profit from a straddle, the underlying equity must rise beyond the strike price of the purchased call, plus the initial net debit. Alternatively, you could also benefit if the equity drops below the strike price of the purchased put, minus the initial net debit.
For example, let’s say that you initiated a pre-earnings straddle on XYZ with 10-strike calls and puts. Your total net debit for the position is $1.50. So, you’ll need XYZ to climb beyond $11.50 (call strike + net debit) or fall below $8.50 (put strike – net debit) in order to begin turning a profit. In other words, you’re looking for a move of at least 15% to make money on the trade. Nevertheless, even if XYZ goes nowhere during the options’ lifetime, the most you stand to lose is capped at the $1.50 paid to establish the single-strike trade.
Meanwhile, there’s also a way for bulls to modify the straddle to make more money on an upside move: the strap. While both the straddle and the strap employ puts and calls at a single at-the-money strike, the latter strategy utilizes twice as many calls as puts. More specifically, to initiate a strap, you would purchase one put and two calls with the same strike and expiration date, resulting in a net debit.
As we alluded to earlier, the objective behind the strap is for the underlying security to make a monstrous move in either direction – but preferably to the upside, since the strategy employs twice as many calls as puts. In fact, should the equity surmount the upper breakeven rail (strike + [net debit/2]) before the options expire, your profit potential is theoretically unlimited, since there’s technically no limit to how high the security could rally.
What’s more, similar to a simple straddle play, the strap allows you to make money on a significant downside move, too. More specifically, should the stock perforate the lower breakeven rail (strike – net debit), your profit could be substantial, but is limited, considering the furthest the stock could possibly fall is to zero.
What do I have to lose, you ask? Should the underlying stock fail to penetrate either breakeven rail, the good news is that – like the straddle strategist – your maximum risk is capped at the initial premium paid for the options. However, since the strap requires you to purchase three options, as opposed to only two for the straddle, your net debit will typically be higher on the play.
In similar fashion, bearish bettors can modify the straddle to dangle a slightly larger carrot on the downside. More specifically, the strip allows pessimistic options speculators to gamble on a post-earnings retreat, but hedge their bets in the event of – and even profit from – a significant post-earnings rally.
To initiate a strip, you would purchase one call and two puts with the same strike and expiration date, resulting in a net debit. As we’ve already mentioned, the objective behind the strip is for the underlying security to make a monstrous move in either direction – but preferably to the downside, since the strategy employs twice as many puts as calls.
Should the stock perforate the upper breakeven rail (strike + net debit), the investor’s profit could be substantial, and is calculated by subtracting the net debit from the call’s intrinsic value. However, an equidistant move beneath the lower breakeven level (strike – [net debit/2]) before the options expire would generate even grander gains, due to the double dose of long puts.
Should the underlying stock remain pinned between the breakeven rails, your maximum risk is capped at the initial premium paid for the options. However, since the strip requires the investor to purchase three options, as opposed to only two for the straddle, the net debit will typically be higher on the play.
Finally, the long strangle is similar to its meeker straddle cousin, in the fact that employers of this strategy are rolling the dice on a significant move in either direction. However, while the straddle centers on just one strike in the same series, the strangle is built using calls and puts at different strikes, each one slightly out of the money.
What’s the benefit to spreading out these strikes? In the simplest terms, the premium for slightly out-of-the-money options will be comparatively slimmer than what you’d pay for their at- or near-the-money counterparts. As such, the strangle is typically cheaper to initiate, which translates into fewer dollars at risk.
On the other hand, splitting the strikes means wider breakeven rails (put strike minus net debit on the downside; call strike plus net debit on the upside) than that of the straddle, meaning you’ll need a relatively larger move from the underlying equity to make money on the play.
Returning to our earlier example, let’s assume that XYZ has one-point strike intervals, and the shares are currently right at $10. To build a pre-earnings strangle, you could buy a 9-strike put and an 11-strike call, bringing your total premium to $1. The breakeven calculations are the same — you make money on a move above $12 or a drop below $8. As you can see, the trade-off for the lower cost of entry is that you need a more aggressive price change in the underlying shares than the straddle trader.
Word to the Wise
In conclusion, keep in mind that like you, everyone else in the market knows that earnings season is all about major price moves. As such, the expectation for a significant post-earnings price change will already be priced into your options, thereby hiking your premiums (and making it more difficult for you to capture a profit).
In other words, the more you pay to buy your options in the first place, the greater move you will need from the underlying stock to turn a profit. And here’s the kicker — implied volatility generally implodes post-earnings, as the news is priced directly into the stock itself, rather than being priced into the stock’s derivatives. Lower implieds mean lower premiums… which means your options could actually lose value, even if the shares make an impressively drastic move.
For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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