While many investors are paying close attention to the European
debt crisis, and potential concerns rising out of China in terms of
demand, there is still time to profit from the volatility brought
about by the current earnings season. Sure, the current crop of
companies reporting has slimmed some, but there are still plenty of
prospects on the horizon. This week alone, we have Joy Global Inc.
), Suntech Power Holdings Co. Ltd. (
), and The Cooper Companies Inc. (
) releasing their quarterly reports. As such, options traders still
have plenty of opportunities to benefit from this period of
Now, many intermediate options traders have heard of strategies
like straddles and strangles, and these plays work well during of
periods of increased volatility by allowing the investor to profit
regardless of the stock's directional move. The catch is that the
stock has to move big, which is kind of the idea during periods of
elevated volatility. But, what if you have a directional bias on
the underlying stock?
Straddles and strangles may not have an opinion on which
direction the shares of XYZ Oil Drillers Corp. moves post earnings,
but you have your suspicions that the stock is due for a plunge.
Luckily for you, there is a way to increase your payout on a
decline in XYZ shares, while still maintaining a "hedge" against an
upside move: the strip.
Constructing a Strip
Strips are quite similar in construction to straddles. Instead
of purchasing one at-the-money put and one at-the-money call, the
strip trader will purchase one at-the-money call and
at-the-money puts. This gives the position a bearish bias toward
the underlying shares.
Let's take a look at an example. Sticking with your negative
bias on XYZ Oil Drillers, you expect the company to report weak
quarterly results after the close on Friday. However, the market
being what it is lately, not to mention the unpredictable nature of
earnings reactions, you feel that you need some upside exposure.
With XYZ trading at $52 per share, you purchase one June 52.50
call, last asked at $1.57, and two June 52.50 puts, last asked at
$1.10 (or $2.20 total). As a result, you enter the trade with a net
debit of $3.77, which represents the most you can possibly lose on
There are a couple potential outcomes for this strip position.
Under the best-case scenario, XYZ greatly disappoints Wall Street
with its quarterly report, and plunges significantly below $48.73
per share (the lower breakeven level). Keep in mind that a rally in
the underlying stock is preferred because you have bought two puts
for every one call. Assuming that XYZ closes at $45 per share at
June expiration, the purchased June 52.50 call would expire
worthless, while the two purchased June 52.50 puts would be worth a
combined $15. Subtracting the net debit of $3.77 paid at
initiation, your profit comes in at $11.23.
Your next best outcome for this strip strategy is for XYZ to
rally above $56.27 per share (the upper breakeven level). Assuming
that XYZ blows past investors' expectations with its quarterly
figures, and the shares rally to $60 per share, the purchased June
52.50 puts would expire worthless, while the June 52.50 call would
be worth $7.50. Subtracting the net debit of $3.77 paid at
initiation, your profit comes in at $3.73.
The only way to lose in this example is for XYZ shares to have
practically no reaction to their earnings data, leaving the shares
essentially flat at expiration. However, even in a worst-case
scenario where XYZ closes at $52.50 per share when June options
expire, your losses are limited to the net debit of $3.77 paid at
It may seem like the strip is the answer to the aggressive
bearish trader's prayers, but options strategies that revolve
around high levels of volatility are rarely as cut and dried as
they seem. Just remember that while high levels of volatility are
beneficial to a strip position, they can also increase the cost of
entering the trade. Furthermore, trading around events, such as
earnings reports and trial results, can be extremely risky. So,
while the strip can give bearish traders a way of participating in
volatile price swings, there is still a palpable degree of risk
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