Using the “Straddle” and “Strangle” to Profit from Volatility

When stocks undergo major price swings – due to earnings rumors, earnings news, or sector/market volatility – it’s a trader’s dream.

And it doesn’t matter which way stocks move; just that there is price movement.

The two techniques we’ll show you today are what traders use to profit off of volatility in either direction. After you read this, you’ll be able to set up for profits when you get ahead of a likely share price move.

You should already know how call and put options work – we have a primer if you’re not there yet.



Your next step in using options to make more money from stocks is to put them together.

When you know how to do this, you won’t have to pray for a stock to go up or go down. Any movement, up or down, puts money in your pocket.

Here’s how to get started.

How to Straddle a Stock That’s on the Move

The techniques that involve using both the call and the put together are called the “straddle” and the “strangle.”

For both the straddle and the strangle, we’re buying calls and puts in equal amounts on the same security.

Let’s see how it works. We’ll take Amazon.com Inc. (Nasdaq: AMZN) for example. Right now, the stock is hovering around $1,495. If we want to buy a call option with that strike price (an “at-the-money” call) that expires on May 25, it will cost about $65 per share.

Of course, to make money on that trade, you’d need the share price to rise by more than $65 (the premium we paid) over the next month. The price of the option reflects the prevailing sentiment of traders. They think a $65 rise over those next few weeks would be par for the course. We’re betting that Amazon will rise more than that.

That’s simple enough. But what if we’re not sure whether Amazon’s earnings report is going to be good or bad? We’re pretty sure it will move investor sentiment one way or another, but we’re waiting for the news like everybody else.

That’s where the straddle comes in.

Now, on the same order ticket, we’ll buy the put option that’s the exact opposite of the call. The May 25 put option with a strike price at $1,495 trades for $61.

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We can buy as many calls and puts as we want as long as it’s the same amount of each. That way we stand to gain if Amazon’s price goes up or down.

The caveat, of course, is that the premium is higher. With the calls and puts combined, we’ve spent $126 per share on this trade. So we need the stock to move by at least that much (in either direction) for it to pay off.

In other words, this is a technique to use when you think a stock is about to move by a significant margin.

Use the Strangle to Lower Your Entry Costs

If premium on a straddle is too steep a price to pay, there’s an alternative: the strangle.

A strangle is just like a straddle, but with the strike prices spread out: a higher strike price on the call option and/or a lower strike price on the put option.

Choosing a strangle over a straddle is trading one type of risk for another. You pay less money up front, but the stock price has to move more before your option is in the money.

The standard way to do a strangle is to buy call and put options that are equally out of the money. In the case of Amazon, we could buy the $1,530 call option, also expiring on May 25, for just $30.

Then, we’d buy the $1,460 put option for $47.



(The put option turns out to be a more expensive than the equivalent call option, because traders are concerned about this stock’s downside right now.)

Now our strangle trade costs $77 per share instead of $126. Of course, we now have two out-of-the-money options. If Amazon’s share price stays between $1,460 and $1,530, we lose everything.

But if we’re sure the stock will move, this was a cheaper way to make a winning bet.

Let’s take a look at a winning trade recommended by one of our experts…

When to Use the Straddle and Strangle

Back on Jan. 22, the day before its earnings report, Johnson & Johnson (NYSE: JNJ) was trading at $148. An at-the-money straddle, as Money Morning‘s options trading specialist, Tom Gentile, recommended, would have cost less than $6 per share.

After the report, JNJ stock plunged and has now dropped below $140 – far enough to make that straddle a profitable trade.

JNJ

But here’s the thing: Johnson & Johnson’s earnings beat expectations, and so did its earnings guidance.

The company missed slightly on revenue, but that the stock would fall so far in the wake of a decent report demonstrates why the straddle and strangle are such good techniques for this season. Because earnings reports tend to bring out the inherent irrationality in the stock market.

There’s an old adage in investing: “Buy the rumor, sell the news.” A stock might rise on the anticipation of an event, but once the event passes, traders dump their positions, and the stock falls back down.

Thus, stocks may plunge after a strong earnings report only because there’s nothing to be excited about anymore. Or they may jump up after a weak report simply because of increased attention. Or investors may favor one metric over another for whatever reason.

The bottom line here is… trading options through an earnings report is a crapshoot,” Tom says. Betting one way or another (with only a call or a put) puts you “in position to take a huge loss – or miss out on huge profits.”

So rather than try to guess a market reaction, we can use the straddle and the strangle to capitalize on the general volatility we tend to see during earnings season.

Timing, however, is critical…

Timing the Straddle and Strangle: Pick Your Exit Point

There are two ways to use these trades during earnings season: 1) exit the trade immediately before the earnings announcement, or 2) exit immediately after the earnings announcement.

In the first case, you’re profiting on the “rumor.” In the second, you’re profiting on the “news.”

If you open a straddle or strangle on a stock and watch it move in anticipation of the report, you don’t want to wait until after the report comes out and watch it swing right back in the other direction after the report.

You want to catch one swing or the other. Not both.

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Now, the big question: Which stocks should we pick?

Finding the Stocks That Are Ready to Move

An earnings report can get just about any stock moving. But we’re going to look for stocks with upcoming announcements that are under significant pressure to move.

Maybe a stock has been on a major upward climb, and the earnings report will either solidify or undermine those gains.

Or maybe earnings expectations are extremely high, and Wall Street is anxious to see if the company will actually come through.

Or a stock has taken a turn recently, and the report could either continue the momentum or send it back in the other direction.

Let’s see what we can find…

Apr 27: Moody’s Co. (NYSE: MCO) is up an impressive 43% over the last 12 months and has been rising steadily for years. It has, however, been known to dip and spike suddenly, driven in part by earnings reports that rarely line up with expectations. Earnings per share (EPS) estimates for MCO have missed by a significant margin for 17 consecutive quarters – sometimes by more than 15%. After the firm’s last earnings announcement came out in February, the share price jumped 10.6% in eight days. The consensus on the upcoming report anticipates EPS of 1.79, which would be a 21.8% rise from a year ago. In the event of anything unexpected (again), this stock could move sharply in one direction or another.

Apr 30: First Solar Inc. (Nasdaq: FSLR) has risen even more sharply over the last 12 months, from $26.80 to about $75 today. The stock has been up and down with the rest of the market over the last few months and just had a sharp rise in mid-April, which it has since retreated from. This is a company whose EPS can change sharply from one quarter to the next, even as it remains profitable over the long term. For example, in the third quarter of last year, FSLR crushed EPS expectations by over 130% thanks to selling certain assets and some pre-tax restructuring. In a case where the stock movement came as much from the anticipation of good news as from the announcement, the stock rose 29% in the couple weeks before and after the earnings date.

First Solar’s EPS went negative last quarter. Even though the long-term outlook is positive, analysts expect an EPS of -0.04 in the upcoming report. Given the stock’s meteoric rise over the last year and the general shakiness in the market, it wouldn’t be surprising to see this one fall lower. But beating expectations (which First Solar has been known to do by huge margins) could send the stock even higher.

FSLR

May 1: Under Armour Inc. (NYSE: UAA) rose 26% in the week leading up to its last earnings report, then leveled out as its EPS came out exactly as expected (at zero). A similar pattern happened in reverse three months earlier, when the stock dropped 33.5% in advance of its Oct. 31 report, which came out better than expected. The stock then slowly crept back up in the following weeks.

Right now, Under Amour is holding pretty steady a couple weeks ahead of its report. But this illustrates the importance of getting out of an option at the right time. If there’s significant movement ahead of the earnings report, you’ll want to close your position before it bounces the other way. This company has seen altered fortunes over the last year, and the continued uncertainty surrounding it could be an options trader’s gain.

May 2: Clorox Co. (NYSE: CLX) has a history of big movements around earnings calls, and not necessarily in predictable ways. After mildly beating EPS expectations in October, the stock saw a steady 18.3% rise over the next five weeks. But when CLX crushed earnings expectations by 44% in the next quarter, the share price fell 9.5% in four days – a few days before the rest of the market would experience a pullback. Analysts are projecting an EPS of 1.31 for the most recent quarter, which would be exactly on par with the same quarter last year. But history tells us we can expect the unexpected.

May 3: Arista Networks Inc. (Nasdaq: ANET) has had a fantastic run lately, rising 80% over the last 12 months. But that’s after slipping 12.5% from its March high during the market pullback. The range between ANET’s 52-week high and low is a jaw-dropping 138%, and it has certainly been prone to quick swings. The stock jumped 32% in the four weeks after its Nov. 2 earnings call, when it crushed earnings. ANET then dropped 23% over two weeks after its February announcement. That drop came in spite of exceeding expectations by a wide margin once again, showing just how anxious the market was at the time. This upcoming earnings call could easily bring about another big swing traders can capitalize on.

Happy trading, and be sure to follow Tom Gentile for more tips on how to rack up fast profits with options.

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