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Feel like strangling the market?
Don't worry, we all do sometimes.
Of course, the strangle I'm talking about isn't the choke hold some of you are thinking about, but rather a strategy to play both sides of the trade and, potentially, profit no matter which direction the market goes.
In this week's Screen of the Week article, I talked about earnings surprises and how you can take advantage of them after a company reports.
But in this piece I want to talk about how you can trade the potential for an earnings surprise (or any big event for that matter) before it happens and without having to worry about whether you guessed correctly or not.
With strangles and straddles you can do just that.
First off, a few definitions:
A strangle is when you have both a call and a put option, with different strike prices (both out-of-the-money) and with the same expiration dates.
A straddle is when you have both a call and a put, with the same strike price (both at-the-money usually) and with the same expiration dates.
Both strategies are used to position oneself on either side of the market in an effort to take advantage of a potentially big move in either direction.
This could be before an earnings release. Or a key announcement. Or a big report. Anything where you believe a potentially big move might occur.
Last quarter's earnings season gave plenty of opportunity to implement these types of strategies.
With every earnings announcement, it seemed as if a surprise up or down saw a double-digit price move, often right at the open, in a big gap fashion.
If you guessed right, you were a hero. If you guessed wrong, you weren't.
And in many instances, it really was a guess. In part on what the company was going to say, but also on how the stock would react.
But with a straddle or a strangle, you could get properly positioned for pretty much anything.
For example: let's say a stock was trading at $100 right before their earnings announcement.
And you decided to put on a strangle by buying the $105 calls and the $95 puts.
And since you only planned on being in the trade for a few days to a few weeks, you got into an option with only a few weeks of time left until expiration. (If you don't need a lot of time, this helps keep the cost down.) So let's also say the call was trading at $3.30 and the put was at $3.20.
Now it's earnings day and the company posts a terrible negative surprise and the stock immediately drops by -15% or -$15. And in the following few weeks, it drifts lower by another -$5 for a total drop of -20%.
The call option just got sacked. But the put option is soaring.
Now let's say its expiration.
With the stock at $80, the call option is out-of-the-money and has expired worthless for a loss of $330.
But the put option is $15 in-the-money, which means the put option is worth $1,500.
So let's look at the math.
- The strangle cost me $650 to put on.
- I lost -$330 on the call.
- But I can sell the put for $1,500, which is $1,180 more than what I paid for it.
- $1,180 profit on the put minus the -$330 loss on the call = $850 profit on a $650 investment for a 130% return.
As for the stock, if you guessed right and went short before the announcement, you made $2,000 on the trade, or a 20% return.
If you guessed wrong however, you lost just -$2,000 or -20%.
With the strangle or straddle, even if you expected it to go one way and it went the other, it doesnt matter -- you still would have profited.
If you put two strangles on, your profit would have been $1,700. And the investment to do so still would have been a fraction of the amount of money you would have had to put up to get the stock.
Of course, this strategy is not without its risks.
You can lose all of your investment, which means the $650 in this case. But that's probably at least what you would have been willing to risk to get into the stock.
In short, as long as there's a big move, you stand to profit nicely. If the market doesn't make a big move one way or the other, both sides of the trade would expire worthless.
The next time you're expecting something big to happen, but not quite sure which direction it'll be, try putting on a strangle or a straddle and be prepared for anything.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.