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Two Candidates For An Earnings Straddle

By: Martin Tillier
Posted: 1/21/2014 10:34:00 AM
Referenced Stocks: ABT;SNDK

Earnings season is in full swing. For long term investors who follow the market without actively trading, this is a time of worry. They can check their accounts one day and see that something that has been doing well has suddenly taken a hit. (Of course they could also see something jump significantly but, oddly enough, that holds less of most people’s attention.) For those with a more active, traders' mentality, however, it is a time of opportunity. Where there's news, there's movement, and where there's movement there's opportunity.

In order to benefit from that opportunity, you don't necessarily have to have a view on the company or its likely earnings number. A straddle is a fairly simple options strategy that is designed to profit from volatility, regardless of the direction. Volatility in options is a scary concept to those new to that market. Experts, when talking about it, invariably lapse into Greek and casually drop complex mathematical formulae into the conversation. It doesn't have to be that complicated, however.

By buying a close to the money call (an option to buy at an agreed price-the "strike price"- that is, close to the current price, at any time up to an agreed end date- the "expiration") and a close to the money put (the same, but to sell) with the same expiration date, you can set yourself up to benefit if the stock moves, whatever the direction. Your outlay and therefore your maximum possible loss is what you must pay for these two contracts- the "premiums."

Your loss would occur if the earnings were as expected, management made no surprising adjustments to guidance, and the stock didn't move. In that case, both contracts would expire worthless and the premium for each would be lost. Profit would come with any surprise and a move to a level higher or lower than the strike price of the option plus or minus the two premiums combined. For example, if you were to buy a 30 call on a stock for 1.00 and a 30 put on the same for 1.30, your profit would come above 32.30 (30+1.00+1.30) or below 27.70 (30-1.00-1.30).

Obviously, around earnings time volatility is more likely and that is reflected in the price of the options themselves. In some cases, though, this strategy can still be employed relatively cheaply; expectations are that estimates will be accurate, so there is not too much volatility expected. Remember, though, what you are looking for is a surprise.

Abbot Laboratories (ABT) will release earnings tomorrow (Wednesday) and looks to be a decent option for a fairly inexpensive straddle. Now I don't claim to know whether the news from ABT will be good or bad, but I don't have to. My belief that a straddle on the stock may be worthwhile is simply based on the current cost of the trade and the history.


The above chart for ABT shows the last earnings release date as a vertical yellow line. As you can see, there was a significant reaction. Despite that, the options pricing suggests that little movement is expected this time. One could, using the last trade from Friday, purchase a call that expires on Feb. 14th with a strike of 40.00 for 0.50 per share and a put with the same expiration and strike for 1.22.

This gives a total outlay of $1.72 per share, or around 4.3% of Friday's closing price of $39.40. Any move of more than 4.3% following tomorrow’s earnings, then, would result in a profit and given the reaction to the last quarter’s results, that looks like a decent bet.

A straddle doesn't necessarily have to be cheap to appeal, however. Sometimes it can appear somewhat expensive, but for those with an appetite for risk may be worth taking. This is especially true when expectations for a company’s performance have become exaggerated, either up or down. A look at the earnings surprise history for Sandisk Corporation (SNDK), for example, shows a tale of analysts desperately trying to keep up with rapid earnings growth.

Consensus estimates for Wednesday's announcement is that earnings will come in at around 1.47, over 20% higher than last quarter and around 50% higher than the same quarter last year. If those estimates have now overshot the mark, there will be a lot of anxious longs looking to sell, but similarly, if SNDK continues to beat even rising expectations then there will likely be a large reaction the other way. The last three earnings releases (vertical yellow lines) have seen significant movement in the subsequent week.

Given that, even paying a combined $6.17 (8.33%) for a 74.00 February call and a put with the same strike and expiration could prove worthwhile.

Now it must be said that straddles are, by their nature, risky and somewhat binary in outcome. You stand to lose everything you put up, so they are not for the faint of heart. I used the word "bet" earlier in this piece for a reason, but providing that you are only using money that you can afford to lose, they can be immensely profitable when they pay off. ABT and SNDK are different types of opportunities, one cheap and the other not so much, but both offer the possibility of decent returns should results tomorrow deviate from expectations.