The Straddle: More Options for Earnings Volatility

      An Educational Piece from Optionshouse

This is Part II of a two part educational series on trading options using WhisperNumber's Whisper Reactor data and services. A Whisper Reactor is a company that is most likely to see a positive price reaction when they beat the whisper number, and see a negative price reaction when they miss the whisper number. The 'whisper reactor' companies, and expected price movement following earnings release, are available to subscribers of the Whisper Reactors service.

The majority of our clients not only 'buy' and 'short' stocks with the Whisper Reactor data, but also trade options as it can offer higher leverage with lower risk. These two reports, provided by Options News Network (ONN.tv), provide detailed information on the essential options trading strategies most likely to be used along with our Whisper Reactors data.


THE OPTIONS STRADDLE

In our report on "Option Opportunities with Earnings Volatility," we introduced the power and versatility of buying calls or puts to capitalize on Whisper Reactor earnings events. In situations where an investor is uncertain about an earnings beat or miss (in the weeks prior to the earnings release), another way to play the event is to look at both a call and a put for the underlying stock in question. The option straddle is a strategy involving the purchase of both a call and a put on the same stock.

"The option straddle is a strategy involving the purchase of both a call and a put on the same stock."
Prior to the actual earnings report being released, an earnings 'beat or miss' is always uncertain, but surprise and volatility are still expected from a Whisper Reactor stock. In situations where the economy, industry trends, or company-specific news are creating more uncertainty, that surprise and volatility may be more extreme. In this scenario, one of the best option strategies to use may be the long straddle. Buying a straddle involves the simultaneous purchase of both a put and a call at the same strike and expiration. This report will focus on how to position the straddle prior to a company's earnings release when there is an expectation of price volatility.

WHAT'S A STRADDLE GOT TO DO WITH EARNINGS?

Whether you are an active options trader or not, a review of the straddle is in order. Traders use the straddle to establish a position in an underlying stock when they believe a big move could be in the cards but they are unsure of its direction. In short, they are buying volatility before they expect volatility to surge.

For instance, let's say an investor is looking at Apple shares before their next earnings report. He or she believes the stock is poised for a sizable move in either direction, for both fundamental and technical reasons, or based upon WhisperNumber's Whisper Reactor data indicating expected price volatility. With the stock trading around $175, the investor could establish an at-the-money straddle position, where the 175 strike call and 175 strike put are both purchased. By at-the-money, we mean the strike closest to the current stock price. Buying both an at-the-money call and put, the investor has essentially "straddled" the market, taking a position that will benefit if the stock makes a big enough move in either direction.

"Traders use the straddle to establish a position in an underlying stock when they believe a big move could be in the cards but they are unsure of its direction."
This position gives the investor both the right to buy and the right to sell AAPL stock at $175 anytime before the options expire. If this straddle is initiated in options that expire in 40 days, for a total cost of $20, the investor can profit when either the call or the put moves in-the-money by nearly $20 before expiration. By in-the-money, we mean having intrinsic value because one could exercise the option and buy or sell the underlying stock at a profit (less the premium paid for the option). For example, if Apple rallies to $195, the call will become worth at least $20 and the investor will begin to see a potential profit on the straddle purchase. Or, if Apple falls to $155 or lower, the 175 put would begin to see $20 of intrinsic value, thus potentially covering the cost of the straddle.

Even though the at-the-money straddle can cost typically twice as much as just one side (the call or put alone), option traders consider this strategy an overall lower risk because it is not dependent on being right about direction, which is a 50/50 gamble to begin with. And even though most of the premium cost in at-the-money options is time value-as opposed to intrinsic value-once the underlying stock begins a swift and significant move, the increase in premium for the in-the-money option as it gains intrinsic value can more than offset the loss of time value in both options. Time value is simply that portion of the option premium that is not intrinsic and that is based solely on how much time is left to the option's expiration.

WHERE'S THE PROFIT?

To profit, straddle buyers do not necessarily need the stock to blast higher or crater lower and have either the put or the call go in-the-money by the amount paid for the straddle. That's the great thing about options. As soon as an event moves the stock significantly one way or the other as the investor anticipated, a benefit for the straddle buyer is usually achieved when the volatility of the options goes up and the price of the straddle increases.

Remember, option volatility is a measure of the risk premium in the marketplace and when risk is perceived as higher, option premiums naturally go higher because a greater range of movement, or volatility, is being assigned to that stock and its options. So within hours or days of a "surprise" earnings event, the straddle that an investor paid $20 for may explode in value to $25 or higher. This allows a near-term way to profit by selling the straddle back to the options marketplace.

Another "option" for the straddle buyer is to sell the side that isn't working and keep the side that is. In other words, if Apple reports earnings that miss the whisper number, and it starts to drive lower towards your target, you can immediately sell the call and recapture some cash, while keeping the put position to let the earnings 'reactor' effect reach its potential.

OPTIONS EXPIRATION AND THE EARNINGS DATE

"When trading a straddle to express a view about earnings, investors want to buy the options that expire as soon AFTER an earnings announcement, not before."
An important factor to keep in mind about trading options around earnings is to make sure the term of the options sufficiently covers the earnings date and any additional time afterwards that should be allowed for the trading strategy to play out. When trading a straddle to express a view about earnings, investors want to buy the options that expire as soon AFTER an earnings announcement, not before. In other words, an investor needs to buy the expiration month that includes earnings. If the expected earnings announcement were October 20th, an investor would not buy the October straddle, as options always expire on the Saturday following the third Friday of the month, which in 2008 is October 17th. In this case, the investor would need to trade the November or December straddle for earnings.

RISK AND REWARD

Straddle buyers must gage the cost of the position against their view of future volatility and the time left until options expiration. One handy reference that helps is to look at the cost of the straddle and what it tells us about what the options marketplace is expecting for volatility. With 40 days until options expiration, if option market makers are willing to sell you the 175 straddle for $20, this fact says that they believe the stock will stay between $155 and $195 until options expiration. If you buy the straddle, you are obviously buying it from these pros that know options volatility better than anyone. This isn't to say that the pros are never wrong and that conditions don't change; it's just that on that day that was the experts' opinion about future volatility. But you may also be aware of data about the company's expected earnings report and its "whisper number" that give you an information edge that others-even the pros-may not have considered.

When evaluating a straddle, investors must be careful not to buy the straddle at any cost. In our example above, with the AAPL 175 straddle trading for $20, the stock needs to move nearly 11.4 percent just for one of the options, either the put or the call, to be worth at least that much before expiration. Here we say that the straddle is trading for 11.4 percent of strike, since 20 divided by $175 = 11.4%. Investors who follow WhisperNumber.com's Whisper Reactors data should pay attention to how much AAPL has moved in the past on an earnings beat or miss to see if they can expect a move like that before the options expire.

STRADDLES AND WHISPER REACTORS

One simple comparison we can make between WhisperNumber's Whisper Reactors and their straddles is to look at the expected post-earnings price move and the straddle premium as a percent of strike. If the expected move for AAPL on an earnings beat is +10% and the straddle is priced at 15% of the at-the-money strike, the options may seem expensive because they are already "pricing in" a bigger move than the Whisper Reactor expectation. This doesn't mean that you can't profit from the earnings beat, though, because as discussed earlier, a big enough move in the stock may boost the value of the straddle enough to realize a gain.

"...when the straddle is close to the Whisper Reactor 'expected move', it may be cheap..."
And remember, the straddle is pricing in a longer time period, possibly several weeks beyond the earnings event depending on what options are bought. Comparing the at-the-money straddle's percent of strike to the Whisper Reactor expected move is really beneficial when the straddle is priced very close or very far away. In other words, when the straddle is close to the Whisper Reactor expected move, it may be cheap and when the straddle is much higher than the expected move - say 20% for the straddle vs. 5% for the move - then the straddle may seem too expensive.

MORE ON RISK AND REWARD

Another factor to keep in mind is that the last month or so of an option's life can see an accelerated loss of time value, that portion of the option's premium that is not intrinsic, or not in-the-money. If the option trade does not seem like it will be profitable in the coming days or weeks because the stock is not moving the way an investor had hoped, closing the option position and taking what is left before all the time value evaporates is always a good idea.

As always with options, the good news is that buyers have clearly defined and limited risk. In this example trading AAPL earnings, paying $20 for the 175 straddle means your maximum risk is limited to the total premium, or $2,000 per contract since each option contract equals 100 shares. Whenever an investor buys options, his or her risk is limited to the premium paid. And obviously, option straddles can be bought for much less than $20 for lower priced stocks and those with lower volatility than AAPL. An at-the-money straddle that you can pay $5 for has lower maximum risk and requires a much smaller dollar move in the stock to profit.

WHAT FRONT-MONTH STRADDLES CAN TELL YOU ABOUT A STOCK

The CBOE volatility index, the VIX, is a widely followed barometer of volatility expectations for the market as a whole. But what can we use to gauge the market's prediction of future moves for an individual stock? For that, the front month at-the-money straddle can provide a good indicator. By front month, we mean the straddle with the expiration closest to the current date. Though we wouldn't want to trade the front month straddle before an earnings event if those options expire before the earnings are released, we can still learn a lot about expected volatility by simply watching the day-to-day changes in premium of the at-the-money straddle.

The key thing that option traders will look at in the straddle, again, is the increase or decrease in that straddle premium as a percentage of the strike price. We'll take an imaginary stock, XYZ. Let's say we go home on a Wednesday and the front month at-the-money straddle is the $25 strike because the stock is trading 25.61. The straddle closes at 3.55, which is 14.2% of strike. Then on Thursday morning, the stock is unchanged, but the straddle suddenly jumps up to $4.80, or 19% of strike.

Just as when the VIX jumps we call it a sign of fear, in this example, that spike in the straddle indicates that traders are expecting the stock to make a move between now and expiration. Had the straddle done the opposite and DECLINED, investors can infer that the market is forecasting the stock to move LESS than it had the day before.

Using options to capture the potential volatility of a Whisper Reactor is a highly favorable risk/reward approach. Limited risk (for option buyers) and relatively higher leverage (versus buying or shorting stock alone) make options a solid choice for playing the uncertainty and volatility of an earnings event. As always, be sure to consult your broker or financial advisor before initiating any options trading strategy.

Written by Kevin Cook, Optionshouse



Kevin Cook was an institutional foreign exchange market maker for 9 years before signing on with the Optionshouse Options News Network as an options instructor and market analyst. He studied philosophy in college and wanted to teach, but ended up on the floor of a commodity exchange where he learned trading and derivatives from the ground up.


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