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Know Your Options

With earnings season set to officially begin next week, here's an options strategy that's perfect for a company about to report.

A straddle involves buying both a call and a put at the same strike price (at-the-money) at the same time.

With options, you buy a call if you expect the market to go up. And you buy a put if you expect the market to go down.

A straddle, however, is a strategy to use when you're not sure which way the market will go, but you believe something big will happen in either direction.

And earnings season is a great time to do this because very few things can send a stock soaring or plummeting like an EPS surprise.

For example: let's say a stock was trading at $100 a few days before their earnings announcement. So you decide to put on a straddle by buying:

  • the $100 strike call
  • and the $100 strike put

Because you only plan on being in the trade for a few days (to maybe a few weeks), you decide to get into the soon-to-expire options.

Note: usually, I'll advocate buying more time and getting in-the-money options. And I still do -- when playing one side of the market.

But when playing both sides of the market simultaneously for an event you expect to take place in the near immediacy, the opposite is best. Why? Because at expiration, your profit is the difference between how much your options are in-the-money minus what you paid for them. So if you don't need a lot of time, this keeps the cost down and your profit potential up.

If you paid $150 for an at-the-money call option that will expire shortly and another $150 for an at-the-money put option that will expire shortly, your cost to put on the trade was $300 (not including transaction costs).

If that stock shot up $10 as a result of a positive earnings surprise, that call option that you paid $150 for would now be worth $1,000. And that put option would be worth zero ($0).

So let's do the math: if the call, which is now $10 in-the-money, is worth $1,000; then subtract the $150 you paid, and that gives you an $850 profit on the call.

The put, on the other hand, is out-of-the-money, and is worth nothing, which means you lost $150 on the put.

Add it all together, and on a $300 investment, you just made a profit of $700. Pretty good - especially for not even knowing which way the stock would go.

However, if you paid more for each side of the trade, those would be extra costs to overcome.

But by keeping each side's cost as small as reasonably possible, that leaves more profit potential on the winning side and a smaller loss on the losing side.

Moreover, if the stock stays flat (in other words, the big move you expect to see doesn't materialize, thus resulting in both sides of the trade expiring worthless), your cost of the trade was kept to a minimum.

So buying a straddle by its very nature should be looked at as a short-term trade. If the outcome of the event that prompted you to get into the straddle in the first place now has you strongly believing that a continuation of the upmove or downmove is in order, you could then exit the straddle and move into the one-sided call or put and apply the in-the-money and more-time rules for those.

Here are 5 optionable stocks due to report earnings over the next two weeks (7/8 thru 7/19) that could see some volatile price action one way or the other:

(APH - Analyst Report) Amphenol Corp.
(reports on 7/18)

(DO - Analyst Report) Diamond Offshore Drilling, Inc.
(reports on 7/18)

(JNJ - Analyst Report) Johnson & Johnson
(reports on 7/16)

(PM - Analyst Report) Philip Morris International, Inc.
(reports on 7/18)

(SLB - Analyst Report) Schlumberger Ltd.
(reports on 7/19)

Whether they report a positive or negative surprise, a big move could be seen in either direction. And the cost of these straddles are very reasonable.

You can learn more about different types of 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.

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