Viable Options Trading Strategy?

Question

Hi

Relatively new to options trading.

When trading Options / Equities, is it generally profitable to look for companies with upcoming results, and formulate a straddle to profiteer from shifts both ways?

Assuming of course they meet decent volatility and volume standards.

I've never tried this, but am curious about how the success ration would actually work out based on the last couple of years.

Answer 1

Long straddles in anticipation of upcoming results is certainly a popular strategy.It has the advantage of limited risk with the potential of unlimited profit.

The biggest problem with the strategy is that option prices tend to be high prior to results but, once the results are out, implied volatility collapses and decreasing the amount of extrinsic value (time premium) in the options. That means in order to profit the underlying has to move enough not only to pay for the unprofitable leg, but enough to overcome the collapse in the premiums as well.

As a result, you will probably lose money on a majority of these straddles. Of course, one large gain can compensate for many small losses, so you may very well have more losses than gains but still find the strategy profitable. It depends on how well you choose which straddles to buy.

If you try the strategy I suggest you ratio it to make it delta neutral. For example, if the call has a delta of 0.40 and the put has a delta of -0.60 I would suggest buying three calls for every two puts you buy.

You can find a fair amount of discussion about straddles on the Yahoo message boards dealing with options. Here is one thread showing the impact of a collapse in implied volatility.

http://messages.yahoo.com/Business_%26_Finance/Investments/threadview?m=tm&bn=4686677&tid=3693&mid=3693&tof=-1&rt=1&frt=2&off=1

You can use the message board search facility to find more if you want. The only person I know who has posted on the boards regularly and does a lot of long straddles is "born29" if you want to look for his posts. (Fair warning, Yahoo message boards contain a lot of garbage you have to sift through.)

I am not particularly fond of long straddles in my own account. There is a paragraph I have quoted several times on the message boards that may interest you from Natenberg's book "Option Volatility & Pricing" (page 187):

"While there is no substitute for experience, most traders quickly learn an important rule: straddles and strangles are the riskiest of all spreads. This is true whether one buys or sells these strategies. New traders sometimes assume the purchase of straddles and strangles is not especially risky because such strategies have limited risk. But it can be just as painful to lose money day after day when one buys a straddle or strangle and the market fails to move, as it is to lose the same amount of money all at once when one sells a straddle and the market makes a violent move. Of course, a trader who is right about volatility can reap large rewards from straddles and strangles. But an experienced trader know that such strategies offer the least margin for error, and he will usually prefer other strategies with more desirable risk characteristics."

In that quote the phrase "straddles and strangles are the riskiest of all spreads" is emphasized.

Answer 2

This is indeed an interesting strategy if it is expected that there will be some surprises in the results, causing a good movement in one direction. In this situation the gain on one option will go faster than the loss on the other option, allowing you to make a profit. The stronger the effect is in one direction, the stronger the profit generating effect of the straddle.

Two remarks of caution however:

You need to realize with this strategy you are exposed to two bid/ask spreads, so the price move needs to be significant enough to overcome these spreads.

Often when the market is nervous about upcoming results, there is an increase in volatility, making the options more expensive. This will be the case for both calls and puts. If results are announced, and certainly if they are not a big surprise, you can see volatility drop significantly very fast. This will be very bad for your strategy, since you had to buy at higher volatility, and sell at lower volatility. Even is there is a good directional move, you may still find it difficult to make a profit on the position in this situation.

Answer 3

Yes, you are on the right track for sure. Obtaining data right before an earnings announcement is pricey. Orangutantrader.com provides a service that offers best picks the day before the earnings announcement. If you get into the trade the day of the earnings announcement, you are too late...must be the day before. This is high frequency, short term trading stuff and a lot of fun as well.

Answer 4

Excellent strategy.