Ok…I shall attempt to illustrate a typical earnings straddle/strangle trade. I was going to do both CROX & HANS, but they turned out almost identical.
The general idea/strategy is always the same (related posts: here & here):
- Buy so that there is a full trading day before earnings. This lets you take advantage of any pre-earnings run-up.
- Sell ‘losing’ leg once you think a direction has been set.
- Ride the ‘winning’ leg as long as possible.
Let’s take CROX, reporting Wednesday (5/7) after the close, as a concrete example:
- Straddle bought Wednesday (5/7) at the open. May 2008 10. Calls @ 0.9/contract coupled with May 2008 10. Puts @ 0.85/contract. Not much action in the stock’s price during the day, so kept them all heading into the announcement.
- Posting a better than expected Q1 and a good outlook, CROX exploded up over 10%. Picking the ‘direction’ in these cases is easy! Sold puts immediately at Thursday’s (5/8) open @ 0.10/contract, booking the 90% loss on those.
- The calls were showing profits of over 150% at the time, so I simply set a stop to guarantee a net profit in the straddle, while giving the calls as much wiggle room as possible… Went with my usual ~30% trailing stop, which translated to 0.30 in this case. Just a little over a half hour later that stop was hit and the calls were sold @ 1.95/contract (116% gain).
The overall profit on the straddle was 17%, which isn’t bad for 1 days’ of auto-pilot work with a low-priced stock.
HANS was almost a carbon copy of the CROX trade but with the calls & puts reversed. I drank a Java Monster in celebration. (Let’s hope they don’t take it, and its lower margins, off the market.)
I do prefer it when I can let the ‘winning’ leg run a bit longer than 30-40 minutes, as it tends to result in higher profits. Even better yet is when there is a bit of a pre-earnings pump, allowing me to sell part of the position and guarantee a profitable trade even before any numbers are announced. But an example of that will have to be left for another day…
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real life examples definitely help! thanks dpeezy
this is why you are KOTPG.
fantastic, clear, simple explanation.
I would think that the options writers would put enough premium into the contracts to make this kind of trade unprofitable?
DP, thanks.
I would love it if you would detail more options trades like this. I’m weak in understanding options plays.
Prospectus:
Generally, you need a 10%+ move in the underlying for such a trade to become instantly profitable.
If the stock moves less drastically but does trend in a certain direction, the trade will become profitable over a period of a few days.
However, if it stays flat or just thrashes, the trade will end in the red.
So no, it’s not always a slam dunk trade. But as with any other trading strategy, it can produce consistent profits as long as you manage your losses. If there is no reaction to the earnings/major news/whatever other catalyst that you were using as your ‘play’, get rid of the position (taking the loss with the premiums) and move on to the next target.