Options Strategy of the Day: A Bearish Pre-Earnings Volatility Play

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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. ( JOYG ), Suntech Power Holdings Co. Ltd. ( STP ), and The Cooper Companies Inc. ( COO ) releasing their quarterly reports. As such, options traders still have plenty of opportunities to benefit from this period of elevated volatility.

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 two 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 the position.

Potential Outcomes

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 initiation.

Profit/loss for a strip example

Wrapping Up

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 involved.

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

Referenced Stocks: COO , JOYG , STP

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