Last week Tesla (TSLA) and Alphabet (GOOGL) both announced Q2 earnings…
They beat revenue forecasts. But earnings per share misses saw both stocks take a serious hit.
And four more of the “Magnificent Seven” will announce earnings this week. That’s Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), and Apple (AAPL). So it’s likely that we’re going to see more big swings ahead…
We just don’t know in which direction yet.
If you’re confident in how a stock is going to react to earnings, one strategy is to buy an option…
You can buy a call option if you think a stock is going to rally. Or a put option if you think it’s going to fall.
Where it becomes more difficult is when you’re expecting a stock to break out… but you don’t know what direction that will be.
And that’s what I want to look at today…
A Leg on Either Side
One way option traders deal with this scenario is through a strategy called a “straddle.”
A long straddle is where you buy both a call option and a put option on the same stock at the same time…
You use the same strike price and expiry date for both options. And you also use at-the-money options.
An at-the-money option is as the name implies. It’s where the option’s strike price is the same as the underlying stock price.
So, let’s check out an example with AAPL to see how it works. (And please note that this is not a trade recommendation.)
If AAPL is trading at around $220, then a straddle involves buying an AAPL $220 call option and an AAPL $220 put option.
That’s why it’s called a “straddle”…
You’re buying an option leg to capture a move on either side of the stock price. That means you have a foot on both sides.
At first glance, a straddle might seem like a no-brainer. That’s because it looks as though you can benefit whether AAPL rises or falls.
The call option captures the upside… while the put option benefits if AAPL falls instead.
This strategy might look good on paper. But turning a profit is more challenging than it first seems…
Time Is Critical
The primary reason for this is that you’re paying out two lots of option premiums. And that means you’re dealing with two lots of time decay.
The underlying stock also has to move in either direction by more than those two premiums combined before you make money out of the trade.
That is, you need to recoup the cost of buying both options.
So, let’s go back to our AAPL example…
If our call option and put option cost $15 combined, we need to recoup that $15 before we break even on the trade…
That means if AAPL is currently trading at $220, it will have to rally above $235 before expiry (that is, $220 plus $15) before we make money from a rally in AAPL…
Or fall below $205 by expiry ($220 minus $15) if we’re to make money from AAPL falling.
As you can see on the chart of AAPL below, that’s a big move in either direction.
Apple (AAPL)
Source: eSignal
With the clock ticking down to expiry, we could well run out of time before the move comes off.
That’s why before rushing out to buy a straddle, you need to consider another essential ingredient of the strategy…
Free Trading Resources
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It’s About Volatility
The key ingredient that some option traders miss with straddles is volatility.
Volatility plays a massive part in how options are priced.
The more that the underlying stocks swings about, the more that increased volatility gets priced into the option.
That’s why when you buy a straddle, the goal is to buy when volatility is low but increasing. And sell when volatility is high.
The key thing to remember is that increasing volatility flows into the value of both call and put options.
In this AAPL example, the combined value of both options could increase to $20 or even $25 off the back of an increase in volatility.
Meaning that you could close out the trade for a healthy profit irrespective of what direction AAPL takes. And potentially long before both options expire.
Understanding the impact of volatility in a straddle is key to getting the trade to work.
Some folks might see straddles as a bet on future price levels. But professional traders view them as a bet on rising volatility.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict