Buying straddles into earnings is a popular strategy to trade the immediate move in a stock ahead of an earnings announcement.
Here’s our guide to this strategy and its pros and cons.
What Is A Straddle?
The investor buys both a put and a call option on the same stock with the same strike price and expiration date.
Example
For example, suppose Apple (AAPL) is at $150. You might buy 1 call and 1 put, both expiring in one month and with a strike price of $150, for $12 in total.
Now if APPL is greater than $12 away from $150 (ie greater than $162 or less than $138) at expiry you will make money.
Moreover the straddle has a positive delta and so any sharp move before then should increase the value of the trade and allow a trader to sell for a profit.
Why Buy Straddles Before Earnings?
Traders purchase a straddle to try to profit from a big price movement in the stock. The trader may think the stock will rise greatly or fall greatly based on some news, such as a an FDA ruling or a congressional hearing.
One other common catalyst for a big price movement is an earnings announcement.
Each quarter’s earnings being announced can cause the stock to rise or fall substantially if the earnings are significantly different to the market’s expectations.
Suppose, in the above example, AAPL is about to announce earnings, which you expect to be significantly better than the market analysts are predicting. You might purchase the above straddle and, if you are correct, profit on a big move should your prediction prove to be correct.
Risks & Downsides
There are significant downsides to this strategy:
You could be wrong about earnings
Firstly, of course, you could be wrong and the stock doesn’t move. In our example AAPL could announce earnings in line with market expectations and the stock move little.
Theta and Time Decay
The trade is negative theta; over time the trade loses value.
Thus our AAPL position above may start to decay, all things being equal, whilst we hold on to it waiting for earnings.
For this reason traders often purchase straddles close to earnings, knowing they’ll be out of the trade pretty quickly (even if the trade goes against them), and so time decay is limited.
Vega & Increasing Implied Volatility
Straddles are positive vega trades; they are positively correlated to changes in implied volatility, which is high just before earnings. This is as expected: this the market pricing in the potential for a substantial move (ie volatility).
Unfortunately, once earnings is complete, IV drops back to its ‘normal’ level. And the straddle, with positive vega, drops too.
Thus it is possible to own a straddle before earnings and still lose money after a big movement if this positive effect on the straddle, due to delta, is more than counteracted by the drop in IV.
So, for example, suppose earnings is announced just after we have purchased our $12 AAPL straddle. Good news: earnings we better than expected and the shares move to $156.
Due to the positive delta (of 0.65, say) our straddle should increase from $12 to around $16 (ie have an extrinsic value of $6 and a intrinsic value of $10)
But due to the collapsing volatility this intrinsic value falls from $10 to $5, giving a total straddle value of $11 (extrinsic value of $6 plus an intrinsic value of $5).
Therefore, despite the correct earnings call, we have lost money.
Alternative Trade To Buying Straddles Into Earnings
Some traders buy straddles before earnings, but sell before the earnings announcement.
This is mainly a positive vega and delta play. The trader is expecting volatility to rise, protecting them from any time decay, and hopes to profit from any movement before earnings (caused by speculation on those earnings etc).
The other way to think of this is that an at the money straddle price is ‘frozen’ in the 7-10 days before earnings. In our above example the ATM the money straddle would be $12 for several days before earnings. Time decay is being offset by increases in IV.
But that is only if the stock doesn’t move. If it does then, as it has positive delta, the price will rise. The trader therefore enjoys positive delta for ‘free’ for several days before earnings.
However, the trade has so many moving parts, this is a strategy for only the most experienced of traders.
Conclusion
Buying straddles in earnings is a popular trade, but requires a significant move after earnings are announced to be profitable due to the effects of vega and theta.
Buying a straddle and selling before earnings is another popular trade, but one for sophisticated traders only.
