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Straddles and Strangles: Taking Advantage of Earnings Related Volatility

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Earnings season is upon us, and investors all across Wall Street are hoping to take advantage of these potentially volatile few weeks. Large bull (and bear) gaps, upgrades and downgrades, and short squeezes all become increasingly more likely during this period, as companies meet, beat, or miss quarterly expectations. However, while no one can accurately predict what a company will report or how the stock will react, there are options strategies designed to take advantage of these situations. Among the most popular of these strategies are straddles and strangles, as they allow the trader to profit from moves in either direction, as long as the underlying stock moves dramatically.

Straddles and Strangles

A straddle is the simultaneous purchase of an equal number of call and put contracts with the same strike and the same expiration date. (Example: an XYZ August 30 call, and an XYZ August 30 put). When utilizing this strategy, you profit when one of the two options increases in value such that it is worth more than the combined premium paid for the pair. Since this combined premium can be somewhat lofty, straddles are best utilized on a stock that is expected to post a large move before the options expire.

A strangle is very similar to a straddle, with the exception that the call and put options have different strike prices. Typically, the purchased call is out of the money (with a strike above the current stock price), while the purchased put is also out of the money (a strike below the current stock price). Because you are usually dealing with out-of-the-money options, a strangle is typically be opened at a cheaper price than a similarly configured straddle. The lower cost of entry on a strangle, as compared to a strangle, reduces the maximum potential loss, but requires a larger move in the underlying shares in order to reach profitability

The drawback to these strategies is that profits are generally smaller than those garnered by simply buying a call or a put. But, if you were sure which direction the stock was going to move post earnings, you wouldn't be considering a straddle or strangle. Both strategies are hedged positions, meaning that while one side racks up solid gains, the opposite side will lose value. By making this tradeoff, however, you acquire the ability to make money on a sharp move in either direction by the underlying stock. And, like a purchased call or put, losses for the straddle/strangle position are limited to the initial premium paid to enter the position.

Wrapping things up, let's take a look at an example of a typical straddle trade ahead of earnings. Returning to XYZ Corp., let's assume that the company has an erratic history during earnings season, regularly blowing past the consensus estimate and missing it by wide margins. You realize that there is a profit to be made by betting on the shares ahead of the report, but, given the company's uncertain prior performance, picking a direction is quite a quandary.

Luckily, with a straddle position, you don't have to pick a direction. With the stock trading at $55 per share, you buy a August 55 call for $2.60, or $260 per contract, and a August 55 put for $2.20, or $220 per contract. The maximum risk, or potential loss, is the combined premium of $4.80, or $480 per contract. The breakeven points are $50.20 and $59.80, or the strike price minus/plus the combined premium. As such, this particular straddle will reach a profit if XYZ rallies past $59.80 per share, or plunges below $50.20 per share. In a worst-case scenario, the stock closes at $55 per share on expiration, resulting in a loss of the total premium paid to enter the trade.

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 Nasdaq, Inc.

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

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