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Tuesday, October 12, 2010

The magic of the Straddle and the Strangle

Earnings are big movers! That is almost a universal truth. Earnings reports are like fuel to an engine. So today, we will move on to another type of neutral strategies: The Straddle and the Strangle.

As any neutral strategy we don't really care whether the stock moves up or down. But unlike the Iron Condor (where you don't want the price of a stock to move outside an interval), with the Straddle and Strangle you are speculating that the stock will have a huge movement in either direction.

So for example if company ABC is trading at $100 and earnings report is due soon, you can buy a $100 strike price CALL and a $100 strike price PUT at the same time! If company ABC moves strongly in either direction one of the options will lose value while the other will inevitably gain!!! And if the movement is significant the gain in one option will offset the value lost in the other one. Pretty cool huh? The key here is to determine if the company is a big mover!

Let's take for example Google (GOOG) during the last three earnings reports Google has moved sharply the day after the earnings report.

January 21, 2010
Google closed the day at $582.98
Earnings were reported after market close
On January the 22nd Google closed at $550.01 that is a 32.97 points move in one day!!!

If a trader had bought the 590 Straddle on January 21, which means

BUY 1 FEB GOOG 590 PUT $26.50 ($2650)
BUY 1 FEB GOOG 590 CALL $19.15 ($1915)

A debit of 45.65 ($4565) would have been invested.

After the 32 point move the next day, the Put option skied rocketed up to $45.70 gaining 19.20 points ($1920) whereas the CALL option went down to $5.10 losing 14.05 points ($1405). The trader then sells the options:

SELL 1 FEB GOOG 590 PUT $45.70 (+$1920 PROFIT)
SELL 1 FEB GOOG 590 CALL $5.10 (-$1405 LOSS)

This is a winning trade with a $515 dollar profit.

Let's analyze another one
April 15, 2010 GOOG at $595.30 and earnings after market close.
Since there are no options at a 595 strike price, we need to use another variant, we buy a Strangle! The Put option at a strike price bellow current price and a Call option at a strike price above current stock price.

BUY 1 MAY GOOG 590 PUT $18.55 ($1855)
BUY 1 MAY GOOG 600 CALL $19.60 ($1960)

The next day GOOG loses 45.155 points!!! Brutal move that would have killed those playing the bull side.

SELL 1 MAY GOOG 590 PUT $43.25 (+$2470 PROFIT)
SELL 1 MAY GOOG 600 CALL $3.10 (-$1650 LOSS)

NET PROFIT: $820 dollars in one day.

And the most recent one:
JULY 15, 2010 GOOG at $494.02, earnings after market close.
Since there are no options at the 495 strike price, again we buy a Strangle!

BUY 1 AUG GOOG 490 PUT $18.40 ($1840)
BUY 1 AUG GOOG 500 CALL $16.75 ($1675)

The next day GOOG loses 34.41 points. Huge move again!

SELL 1 AUG GOOG 490 PUT $35.05 (+$1665 PROFIT)
SELL 1 AUG GOOG 500 CALL $3.20 (-$1355 LOSS)

NET PROFIT: $310 dollars in one day.

So my friends.....Google earnings are to be reported on Thursday after market close. Judging by the past, buying a Straddle or Strangle before market close on Thursday seems to be a good trade opportunity.

Ok ok ok, I know,.... the SEC says that "past performance is not indicative of future performance". But C'mon! let's face it! What else have you got other than the past?!?! Past performance is a strong clue, and it is because basically that is all you have!! Well maybe I am wrong and you are a fortune teller, I don't know.

One thing to note is that the day after earnings, once Google move is defined to the up or down side you can get rid of the loser option quickly in order to avoid losing more money on it. So, you sell it when it still has some decent value, and then let the winner option run during the day just to see how far it goes ;) After the last 3 earnings reports Google has lost value, so it might be tempting to play the straight Put, but you know I don't like to predict direction ;) so I play it both sides. If you only play the Put side and suddenly Google goes up 40 points you get crushed with a massive loss.

Ok, guys play it safe!!

Check out how this trade on Google played out

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