Unlike Christmas, it comes 4 times a year, and doesn’t make all people happy. It’s the busiest time of the year for fund managers and equity traders around the world. It’s earnings season.
In the old days, if you beat expectations the price of your stock would shoot up, if you just meet them it would generally stay flat, and if you missed them the market would sell the stock. Today it’s a bit harder to figure it out. Companies may report profits, beat estimates, but stocks would drop on weak guidance, or vice-versa.
This leaves the average investor with two options, buy a stock based on solid fundamentals and keep it despite short term volatility, or take blind bets (no different to what they would do on a casino) before the reports, and hope for the best. There is however a third option… options:
There are two option strategies that work particularly well when you don’t know what to expect from an earnings report, but you have it pretty clear that it whatever comes out will move the price of the stock. These strategies are the long straddle, and the long strangle.
This strategy consists in purchasing a call and a put contract, with equal maturities and the same strike price (generally at-the-money or very close to it). The bet is that regardless of how good or bad the earnings report is, the stock will move beyond its normal standard deviation. This is know as longing volatility i.e. betting on the volatility of a stock to increase and therefore increasing the value of the option. The fact that the investor is purchasing a call and a put, means that volatility in either direction would trigger an increase in the price of the option that points in that direction, while the other expires worthless. The goal is for the option that increases in price to do so by more than the combined premiums of both contracts, and therefore return a profit.
The above graph shows the individual call and put option payouts, where the call’s losses would be offset by the put’s profits, just as the put’s losses are offset by the calls profits. Unlike a regular single option strategy, the long straddle takes longer to turn a profit, since the movement on either side needs to offset both premiums. Should the price of the underlying not move enough in either direction, the total outcome will be a loss of either premium offset partially by some salvage value of the other premium. Total loss happens when both options expire at-the-money, and the loss then is limited to the full value of both premiums.
If an investor is expecting a much larger price jump in either direction, he can opt for a long strangle, which in many respects is very similar to the long straddle, except both options are purchased out of the money; therefore the call is purchased with a strike price higher than the market price of the stock, and the put is purchased with a strike price lower than the market price of the underlying.
Although both the strangle and the straddle bet on increased volatility, the main difference is the expected degree of volatility. An investor taking a bet on a long straddle will be willing to take a bigger potential loss should the options expire in or around the money, but start making money faster i.e. expecting a jump, but not a big one. Long strangle investors on the other hand are being more conservative with the principal at play, but they have to wait longer to start seeing profits. For the latter strategy to work the price of the underlying should increase by more than it would in the former strategy.
Strategies may not always work, and many times investors will end up losing their principal, but if picked carefully and timed correctly, it is more likely than not, that these strategies will outperform taking long or short positions on individual stocks.