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

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With events in Europe and China shaping the bigger picture on Wall Street, it is easy to forget that we are smack in the middle of corporate earnings season. While we are about halfway through the current earnings calendar, there are several heavy hitters still scheduled to report. This week alone, we have Hewlett-Packard Co. ( HPQ ), Wal-Mart Stores Inc. ( WMT ), Deere & Co. ( DE ), and Dell Inc. ( DELL ), just to name a few. 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 BrickLayers Corp. will move post-earnings, but you have your suspicions that the stock is due for a rally. Luckily for you, there is a way to increase your payout on a rally in XYZ shares, while still maintaining a "hedge" against a downside move: the strap.

Constructing a Strap

Straps are quite similar in construction to straddles. Instead of purchasing one at-the-money put and one at-the-money call, the strap trader will purchase one at-the-money put and two at-the-money calls. This gives the position a bias toward a rally in the underlying shares.

Let's take a look at an example. Sticking with your bullish bias on XYZ BrickLayers, you expect the company to report blowout 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 downside exposure. With XYZ trading at $52 per share, you purchase one June 52 put, last asked at $1.57, and two June 52 calls, 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 strap position. Under the best-case scenario, XYZ impresses Wall Street with its quarterly report, and rallies significantly beyond $55.27 per share (the upper breakeven level). Keep in mind that a rally in the underlying stock is preferred because you have bought two calls for every one put. Assuming that XYZ closes at $60 per share at June expiration, the purchased June 52 put would expire worthless, while the two purchased June 52 calls would be worth a combined $16. Subtracting the net debit of $3.77 paid at initiation, your profit comes in at $12.23.

Your next best outcome for this strap strategy is for XYZ to plunge below $48.23 per share (the lower breakeven level). Assuming that XYZ sorely disappoints investors with its quarterly figures, and the shares plunge to $45 per share, the purchased June 52 calls would expire worthless, while the June 52 put would be worth $7. Subtracting the net debit of $3.77 paid at initiation, your profit comes in at $3.23.

The only way to lose in this example is for XYZ shares to have practically no reaction to their earnings data, leaving the shares close essentially flat at expiration. However, even in a worst-case scenario where XYZ closes at $52 per share when June options expire, your losses are limited to the net debit of $3.77 paid at initiation.

Profit/loss for a strap example

Wrapping Up

It may seem like the strap is the answer to the aggressive bullish 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 strap 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 strap can give bullish 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: DE , DELL , HPQ , WMT

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