In a tech climate like we are having, volatile markets can lead to incredible gains for aggressive options traders. One strategy option traders employ to take advantage of earnings announcements, is the strangle. A strangle is an investment strategy involving the purchase or sale of a particular option derivative that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. The strategy involves buying an out-of-the-money call and an out-of-the-money put option. Calls are for when you expect the stock to go up, and puts are for when you expect the stock to go down.
To take advantage of tech volatility ahead of earnings reports, I will explain how to trade an option strangle with Zynga (ZNGA) (using the after hours price quote). If you didn't know already, FarmVille creator Zynga reported a second quarter loss of $22.8 million. Below is a calendar of Zynga's options expiring after the close Thursday, July 26 2012.
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In this example, Zynga traded at $5.078 at the close July 25, 2012. After the disappointing earnings, the stock traded at $3.175 on July 26, 2012. The options I'll be trading expire at the close on Thursday, July 26, 2012. Given the short time frame, this is a high risk trade with a rather incredible return. Therefore, the investment in this trade should be small. I spent a total of $415 to execute the long strangle strategy.
To employ the strangle strategy using ZNGA shares, a trader enters into two option positions -- one call and one put. Let say the trader wants to purchase 100 contracts (1 contract = 100 shares) for a call position and 100 contracts for a put position. Say the call is for a $5.50 strike price and costs $190 ($.19 per option contract x 100 shares x 10 contracts), and the put is for a $4.50 strike price and costs $225 ($.15 per option x 100 shares x 15 contracts).
The trader will make money if the price of the underlying starts to move outside of the $5 range. The call options expire worthless and the loss will be $190 to the trader. The put option, however, has gained considerable value. The value of 15 contracts of an in-the-money expired call option would be worth $2,025 ($1.35 per option x 100 shares x 15 contracts). So the total gain the trader has made, minus $190 loss and $415 original investment, is $1,176 -- a 131% profit.
Prior to Zynga's earnings release, another option strategy called a straddle would have netted a huge profit. In option trading, the long straddle, similar to a strangle, is a strategy based on buying a stock option with the same strike price and expiration of both a call and put. Why would an investor want to buy the same strike price and expiration of both a call and put? The goal of a long straddle is to profit if a stock moves quickly in either direction. As I mentioned above, calls are for when you expect the stock to go up, and puts are for when you expect the stock to go down.
In this scenario, employing a long straddle, I would go with options a bit further out on the option calendar. Above is a calendar of Zynga's options expiring at the close on Friday, August 17, 2012. The straddle trade is less risky, given that I have more time to work with. Total cost for the straddle is $1,217.
To employ the straddle option strategy with Zynga, a trader enters into two option positions, one call and one put. The trader wants to purchase 10 contracts (1 contract = 100 shares) for a call and 13 contracts for a put position. The call for a $0.58 strike in-the-money option total cost is $580 ($0.58 per contract option x 100 shares x 10 contract). For an out-of-the-money $5.00 strike put option, the total cost is $637 ($0.49 x 100 shares x 13 contract). The call option will be worthless, and the loss will be $580 to the trader. The put option, however, has gained considerable value. The value of 10 contracts of an in-the-money expired put option would be worth $2,405 ($1.85 per option x 100 shares x 13 contracts). So the total gain the trader has made, minus the $580 loss and the $637 original investment, is $1,233 -- a 98% profit.
*A trader can sell the underlying, in this case ZNGA, at anytime. He or she does not have to hold an option through the expiration date.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.