Earnings are Coming!
Posted on Wednesday, April 12, 2017 at 10:47 AM
The market has been relatively quiet over the last several weeks. Occasionally there has been some volatile days mixed in but as a whole, there has not been much volatility. Sooner or later, volatility will reenter the picture and the upcoming earnings season might just give the market a nudge. Although there is no official start to quarterly earnings, Alcoa Inc. (AA) which is expected to announce on April 24th is widely regarded as the start.
There are plenty of option strategies for option traders to consider where the position is meant to be held over the announcement and we will talk about in futures blogs. But there is also a strategy to consider that is meant to be closed out prior to the announcement that most option traders are familiar with. It is buying a straddle or strange ahead of earnings. Let’s take a look below what a straddle and strangle is if you are no familiar with them.
Keeping it fairly simple, a straddle and strangle is buying both a call and put with the same expiration on the same underlying. A straddle is buying the same strike call and put and a strangle is buying to different strikes. Naturally the position is a debit to your account since both a call and put are purchased. There are two ways in which to profit. Either from delta or vega or both.
Since both a call and put are purchased, it is beneficial for the stock to move distinctly in one direction. Then you will have either positive or negative delta and the trade will benefit from a continued move in the direction of the delta. Up and down action is not beneficial usually. Vega effects option premium based on the implied volatility. Options increase in price when IV rises and vice versa. Since the position is long a call and put, it is beneficial for IV to increase.
What hurts the position is vega sometimes and theta always. A decrease in the IV level would decrease the premium by the amount of vega. And since options are a decaying asset, time passing will always decrease the premium by the theta amount.
A straddle and strangle is implemented when there is an expected move in the underlying and the direction is unknown. In addition, IV is expected to increase. Earnings may be a perfect time to consider this option strategy but there are a few things to consider.
The plan for buying a straddle or strangle based on earnings is to put the position on ahead of earnings and exit the position (hopefully for a profit) before the actual announcement. Of course, the position can be held over the announcement, but a big move is probably needed to profit because the IV will drop and so will the option premium after the announcement.
Although past performance is not indicative of future behavior, it might be beneficial to look at a stock’s previous earnings to gauge if it may be a good candidate. The goal is for the stock to move decisively before the actual announcement. Consider buying the position anywhere from about a month to about a week prior to the announcement. Remember time decay (theta) is a concern so be sure to allow enough time and maybe not just pick the expiration that takes place right after the expected announcement.
What usually benefits this pre-earnings position is vega. Since IV generally rises as the earnings date nears, option premiums should rise as well minus any time decay. If the stock moves decidedly higher or lower after the position is put on and IV increases, it is a win-win for the position. Consider managing the position for profit based on an expected return like a certain percentage. Consider managing the position on the stop loss side of things based on two criteria. An exit at a certain point (like before the announcement) and/or a certain percentage of risk just like for profit.
A straddle and a strangle can be very effective option positions. Using them ahead of an earnings announcement may greatly increase your chances for success if the guidelines above are considered. In future blogs, we will go through an example of this option strategy.
Senior Options Instructor