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Options are the tool of choice when it comes to hedging your equity or exchange traded fund positions. They also allow investors to enhance their positions through call and put writing. Options allow investors to benefit from the power of leverage, providing notional exposure to an underlying for a fraction of the cost of that underlying. All of these strategies are fairly straightforward and relatively easy to implement, involving the purchase or sale of a single, specific contract related to a held position.

What if an investor wants to take advantage of a specific situation but doesn’t want to, or can’t, invest in the underlying directly? Again, our answer is options. While there are a myriad of opportunities in the marketplace as well as corresponding option strategies, I’m going to focus on one opportunity: announcement events. Examples of announcement events include earnings releases, lawsuit resolution, and legislation enactment. Both the Straddle and the Strangle trade were developed precisely for these opportunities. We are going to take a look at what it takes to identify, research, structure and implement these trades by taking a close look at the underlyings fundament history as well as develop a better understanding of just how important examining volatility can be in determining the viability of a trade.

The Straddle

This trade is established by going long the At-The-Money (ATM) call and the ATM put. The payoff diagram looks like a “V” centered on the ATM strike. The main positive of this trade is that it could “win” either way the announcement goes. You could make money on the call or the put if the underlying has a “big move.” One caveat is that because you’re buying two ATM contracts, this trade can be fairly expensive. Investors have to do their homework with regards to how their particular underlying reacts to certain news and make the determination as to whether or not capturing the expected price move is worth the premium involved.

The Strangle

This trade is established by going long an Out-of-The-Money (OTM) call and an OTM put. The payoff diagram looks like an elongated “U” centered on the ATM strike. Because this position is established using OTM contracts, it is less expensive than the Straddle. The caveat here is that the trade doesn’t start “working” until the underlying price has moved to the strike price of either of your positions. As with the Straddle, investors have to do their homework with regards to how their particular underlying reacts to certain news. This means that they need to have an opinion regarding the underlying price’s expected move.

A 'Real-World' Example

GOOG Q3 Earnings (10-13-2011)

Research

All historical numbers presented or calculated are based on actual observed numbers and not theoretical values. Let’s take a look at a recent example of an announcement event. Google (NASDAQ:GOOG) announced its third quarter 2011 earnings on Thursday, October 13th. Let’s say you follow GOOG and know that in Q2, they had an 11.39% earnings surprise and as a result, their stock price jumped 12.98%. Taking nothing for granted, you do some homework and research these same stats going back to Q2 of 2005. You find that in the past 25 quarters, GOOG has had positive earnings 20 times (80% of the time). Further, when GOOG has had an earnings surprise greater than 2.5%, the average surprise is 8.91% and the share price advances 4.79% 18 of 25 times (72% of the time). The average 4.79% return includes results ranging from -5.66% to 19.99%, reminding you that the market can indeed be unpredictable. Armed with this and other fundamental research as well as your “gut instinct”, you come to the conclusion that you expect another strong quarter, including a similar upside surprise of about 10% as well as at least a 5% move in the underlying price, if not more.

In addition to reviewing the fundamental aspects of this trade, you take a look at implied volatility for GOOG. You see that it has been declining ever since hitting a near term peak in early October. This is good because it means you won’t be paying up for the trade due to high volatility.

Modeling the Trade

For this example, I’m assuming that you put this position on one day before the earnings announcement using closing prices.

Straddle

GOOG closed at 548.50 on Wednesday, October 12th. Based on this price, the Straddle position could be established through purchasing the October 550 Call ($20.20) and purchasing the October 550 Put ($22.10) for a combined cost of $42.30. Based on the current spot price, the straddle trade has a breakeven of 7.71%, meaning that a greater than 7.71% move in the price of the underlying (to above 590.80) could put this trade in the black. While you expect at least a 5% move, your “gut instinct” move is really about 10% or higher, and as you’ve modeled out, a 10% move in the underlying would result in a 26.12% return in the position. Even if only an 8% move in the underlying is realized, that still represents a 0.19% gain, which, while not optimal, is still a gain.

Strangle

Given the same assumptions as the Straddle position, you decide that you are going to set up a Strangle position 2.5% away from ATM. This position could be established by purchasing the October 560 Call ($15.80) and purchasing the October 535 Put ($14.70) for a combined cost of $30.50. Based on the current spot price, the straddle trade has a breakeven of 7.66%. This position costs roughly 18% less than the Straddle and given your expectations, has the potential of returning 37.21% on a 10% move in the price of the underlying. Even if only an 8% move in the underlying is realized, that still represents a 1.25% gain, which, while not optimal, is still a gain and higher than the Straddle. Based on this analysis, you decide to go with the Strangle.

Outcome

The earnings announcement happens at the market close on Thursday, October 13th. GOOG surprises 10.95%! GOOG has moved from our entry point of 548.50 to roughly 596 in aftermarket trading and opens slightly higher on Friday at 599.47 for a 9.29% price move. You nailed it! Good to see the old “gut” is still working. You check your model and see that a 9.29% move results in a 24.44% gain.

At the end of trading on the 14th (which is when I’m snapping prices for this part of the example) you go to your online brokerage account and check your P/L for the trade and see that based on the 591.68 closing price for GOOG, the 535 Put you bought is now worth $0.05, but that was to be expected. You look at the 560 Call and it is now worth 32.40. Your total gain on the trade is $1.95! Wait, what? $1.95? That’s only 6.39%. Where is the other 18% you modeled for this trade?

The Search for 18%

When a company reaches some decision point or announcement event, it is creating a certain amount of uncertainty. The greater the uncertainty there is, the greater the opportunity for movement in the stock price. The market generally expresses uncertainty the only way it knows how, through volatility. Once that uncertainty is removed, volatility generally goes with it. When you went through the steps of researching and modeling this trade, you looked at historical post-earnings announcement price moves but did not research historical implied volatility changes for these same periods. It turns out that over the same 25 periods, you observe that the average implied volatility for GOOG changes from 42.43 on the day of earnings to 33.50 on the day after the announcement, a 21% decline! You got caught in a “vol crush!”

Epilogue

There are a lot of moving parts to an options trade even if you’re dealing with a one contract strategy. Once you start putting on multi-position (or multi-legged) trades, things don’t get any easier. As we see here, it is a relatively straightforward process to model a stock’s expected price behavior given an earnings event. In any option pricing model, the price of the underlying is important but what is equally if not more important is the volatility associated with that price level. When considering implementing an option based strategy, it is not enough just to have an expectation of where the price of the underlying is going to be. You must have an understanding and expectation of volatility as it relates to the underlying position. While you may not be completely comfortable with all the Greeks, it is imperative to become the best of friends with Vega. Sure, she’s unpredictable sometimes, but in the case of a recurring event like earnings, history can be a helpful guide as to how she likely might react.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Options Trading On Earnings: Straddle Or Strangle?