From time to time we’ll break away from talking trades to discuss different option trading strategies. Being in the midst of earning season, I think it is important to address the straddle/strangle strategy, since I am getting a significant number of questions regarding these types of trades.
Before we start, let me say that option pricing is a complex topic, and one that you should try to learn inside and out while trading options. If you have an understanding of how options are priced, you’ll be able to determine which strategy is most appropriate and when. We’ll do lots of work on this from time to time, so be prepared to learn.
The reason traders want to trade over earnings is due to the large price swings that are made. The problem with options is that a significant portion of the premium is based on expectations. In short, if you are expecting big price swings, so is the market. Therefore, option premiums take this expectation into consideration and price an “expected move” into the premium.
A straddle is an option strategy where you are buying a call and a put of the same expiration and strike price. A strangle is an option strategy where you are buying a call and a put of the same expiration and different strikes. You can also sell straddles and strangles, but the risk profile is extreme for traders, and ultimately should be avoided. In this post we’ll focus on the long side of this position.
As the buyer of an option, you are paying premiums that have an expected move “baked in” to the price of the option. Not to mention, as the buyer of a straddle or strangle, you are trading two overpriced options where the anticipated move is priced in. This means you have a pretty low probability of success.
To improve the odds of success, you implement these strategies when options are relatively or historically cheap. This strategy works best when you are anticipating a rise in implied volatility (expectations) and stand to benefit in changes in prices as well. Take a look at this chart. This chart reflects the changes in implied volatility for AAPL.
Pay attention to the gold colored line. It reflects fluctuations in implied volatility. The four arrows on the chart reflect where AAPL reported earnings. You’ll see in the last three earnings releases, implied volatility has been at the upper end of its relative range. Today, implied volatility is closer to the bottom of its range.
What this means is that expectations and option premiums have been high into the last three announcements. This time around, they are significantly lower. This interests me. As an option trader, you should live by the mantra “buy when premiums are cheap, sell when they are expensive.” Premiums are relatively cheap here.
While I am not too excited to place bets on both sides of AAPL, I am seriously considering taking a position here into earnings. For the most part, I loathe this idea. I hate to see traders gamble into the face of the unknown, when premiums are stacked against you. However, I like the fact that they are still relatively cheap here, and the general sentiment surrounding this stock.
Final thought: waiting until the last minute prior to an earnings release to buy options is a terrible strategy, generally speaking. However, always pay attention to implied volatility. If you are looking to trade straddles or strangles, buy them in advance while premiums are cheap, or just avoid trading them when they are too expensive.
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