With Q4 earnings season just around the quarter, a number of companies will be reporting critical holiday sales numbers that will set the tone for 2017 and beyond.
With so much at stake this earnings season, there will certainly be some violent earnings-related moves in the stock market. Unfortunately, as traders know all too well, picking earnings winners and losers ahead of time is nearly impossible.
The unpredictability of earnings season leaves traders with few good options. They can gamble on a big earnings beat or miss and hope they don’t get burned. They can also exit positions altogether ahead of earnings and stay on the sidelines.
However, traders can also use a simple options trading strategy to make a bet on a big earnings move, and the best part about the trade is that direction doesn’t matter.
There are hundreds of complicated options trading strategies out there, but the option straddle is one of the simplest. Instead of buying put options to make a bet on an earnings miss or call options to make a bet on an earnings beat, traders can construct a straddle trade by simply buying both puts and calls. For a true straddle trade, “straddle” the stock’s share price by picking a strike price close to the current market price.
There are several key positives to the straddle earnings trade. The most obvious advantage is that traders don’t have to predict whether or not a company will beat on earnings: they can profit either way. Another advantage of the straddle trade is that the catalyst has a clearly defined date (the earnings date). Options are constantly suffering from time decay, but earnings traders can reduce the impact of that time decay by initiating the trade right before the earnings release. Finally, options leverage provides the potential for greater returns on the trade in the event of either a big earnings miss or a big earnings beat, while potential downside is limited to the entirety of your original investment.
Of course, in the financial markets, there’s no such thing as a free lunch. There are several downsides to a straddle trade as well. First, for the call options to be a big winner, the put options have to be big losers; and vice versa. Straddle traders are simply betting that the win from one will be bigger than the loss from the other. Second, the more volatile the stock, the higher the option premium traders will pay. Some of the stocks with the most violent earnings moves, such as Groupon Inc (NASDAQ: GRPN) and Yelp Inc (NYSE: YELP), also have the most expensive options. Finally, if a stock moves very little or doesn’t move at all following its earnings reports, the straddle trade is in trouble. Traders could lose most or all of their entire premium, making the trade extremely risky. Traders should remember this possibility when determining how large of a position to take
Disclosure: the author holds no position in the stocks mentioned.
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