Options trading is often considered a “zero-sum” game in the sense that whatever profit a trader makes, another trader must have lost. Technically this is true because each option purchased has to have been written (sold) by a counter party. If both traders hold the position until expiration without making any other trades, they will exchange shares of stock and/or cash and one of them will make exactly as much profit as the other lost.
In reality, this is rarely the case. Usually, one or both parties engage in additional transactions over the life of the contract that significantly affect the profitability of the trade.
Let’s take a look at a trade that’s popular around earnings announcements that could actually end up being profitable for both sides:
On Monday, Netflix (NFLX - Free Report) was trading around $400/share and was scheduled to announce quarterly earnings after the market close. Investors were focused not only on sales and net earnings numbers, but also on the number of subscribers the company added during the quarter - which has become a barometer for growth at Netflix.
In the options markets, the 400 strike call and 400 put expiring Friday the 20th were each trading around $16.50. The price of the straddle – buying both one call and one put – implied that traders thought Netflix was likely to move $33 in either direction after the earnings announcement. These were fairly expensive options - even prior to a major announcement - as the shares would have to move more than 8% before the buyer saw a profit.
As it played out, they may have been too cheap.
After the announcement - in which the subscriber number was disappointing - the stock plunged over $50 in after hours trading and opened on Tuesday at $347. So buying the straddle for $33 was a big winner, right?
Not so fast.
On Tuesday the stock rallied more than halfway back to Monday’s closing price, trading as high as $382. On Wednesday, the shares are trading back down around $375, and the current prices for the 400 call and put are $0.20 and $25.20, respectively.
The buyer of the straddle had ample chance to lock in a nice profit. Had he bought 100 shares of stock at $350, he would have locked in a profit of $17 on the trade and he would still own two 400 strike calls in case the stock rallied back over $400 before expiration on Friday.
For those of you saying “Wait, he only owns one call…” consider this. He owns one 400 call, one 400 put and 100 shares of stock. If we stay under $400 between now and expiration, he will exercise the put, selling the shares and the call will expire worthless. He'll keep the $50 between where he bought the stock and the strike he sells it at and loses the $33 in premium he paid for the straddle.
If the shares rally above $400, he will not exercise the put and will exercise the 400 call instead, giving him ownership of 200 total shares – just as if he owned two calls.
Long one put + long 100 shares = long one call.
The seller of the straddle may have felt the need to hedge the short trade by selling the shares when the stock was down sharply, in which case he has the opposite position as the buyer – a locked in loss and the risk of being short 2 400 calls. If he didn’t hedge however, he saw his position turn profitable as the shares rallied back on Tuesday and he now has an $8 profit.
We saw that the owner of options could hedge with stock and still retain some optionality in the case of an extreme rally over $400. Conversely, the trader who is short options cannot simply trade stock and have no risk. If he were to sell 100 shares at $375 to lock in the $8 profit, he would still be short two 400 calls just the same way the straddle buyer is long them. So to be truly closed, he would have to also buy 2 400 calls for $0.20 each to have totally closed the position, reducing the profit to $7.60.
The lesson from this trade is that trading options – especially short term options around a scheduled event like earnings announcements – can be profitable whether you’re long or short as long as you’re vigilant about which opportunities exist to hedge the trade to maximize gains and/or mitigate losses.