Options allow you to create strategies that simply are not possible when investing in stocks. There are two ways that you can do this, they are known as strangles and straddles. This is a more complex strategy than simply buying a long call option or a long put. But it’s not really that complicated, you just have to understand some basics on how to set them up in order to make a profit.  

The strategy that is used in this case is dependent on a large move by the stock. There are many situations where this might be appropriate. But mainly, this is something you will consider using when you are looking to profit from an earnings call.  

Earnings calls cause major price shifts in the big stocks. The price shift is largely determined by what the analyst’s “expectations” are for earnings, and so this is not always a rational process. If the company beats the analyst expectations when it comes to earnings per share, this creates a positive “surprise” that will usually send the stock soaring. The amount of “surprise” is given by the percentage difference between the actual value and the expected value. So, in this case, if you had bought a call option, you could make amazing levels of profit from the option by selling it in the next day or two, as long as the new higher price level is maintained. 

But the problem is, you have no idea beforehand whether the earnings are going to exceed or fail to meet the analyst expectations. The silly thing about this (from a common-sense perspective) is that even if the company is profitable, if they fail to meet analyst expectations, this results in massive disappointment. So, you might see share prices drop from a sell-off even if the company is profitable. This is “surprise” in a negative way. 

The impact of failing to meet expectations can be magnified if the company also has some bad news to share. A recent example was an earnings call from Netflix, where they revealed that over the past quarter, they had lost subscribers. This news hit Netflix stock hard, it dropped by a walloping $42. If you had purchased a put option, that could have meant a $4000 profit.  

The problem is that you don’t know ahead of time which way the stock is going to go. It’s one thing to look back and say well you could have had a put option and made $4k in a day, but often companies reveal information in earnings calls that have been under wraps. Nobody had any inkling that Netflix was going to be losing subscribers until the earnings call.  

Second, analyst expectations are somewhat arbitrary. Defining success or failure in terms of them is actually pretty silly, but that is the way things work right now. But the point is it’s really impossible to know whether or not these arbitrary expectations are met prior to the earnings call. It’s also impossible to gauge the level of reaction that is going to be seen from exceeding or failing to meet expectations. 

Since we don’t know which way the stock is going to move, it would seem that a good strategy to use is to buy a call and a put at the same time. That is precisely the idea behind a straddle and a strangle.  

That way, you profit no matter what happens, as long as the price on the market changes fairly strongly in one direction or another. When you set up a straddle or a strangle, there is a middle “red zone” that bounds the current share price over which you are going to lose money. But if the share price either goes above the boundaries of this zone or below it, you will make profits.  

If the stock shoots upward, this means that the put option is going to drop massively in value. So, it’s basically a write off for you. But if the stock makes a strong move, as they often do after positive earnings calls, you stand to make enough profits from the call option that was a part of your trade to more than make up for the loss of the put. The potential upside gain is in theory unlimited. Of course, in practice, share prices don’t rise without limit, but they might rise, $10, $20, or $40, and that could potentially earn profits of roughly $1,000-$4,000, more than covering any loss from the now worthless put option. 

The opposite situation applies as well. If the stock drops by a large amount, you make profits. Profits to the downside are capped because a stock price cannot decline below zero. That said, if the stock drops by a significant amount, you can still make hundreds to thousands of dollars per contract virtually overnight.  

Doing this requires some attention on your part. You are going to have to think ahead in order to implement this strategy and profit from it. Remember that you can use a straddle or strangle any time that you think the stock is going to make a major shift one way or the other. An example of a non-earning season situation, where this could be a useful strategy, would be a new product announcement. Think Apple. If Apple is having one of their big presentations, if the new phone that comes out disappoints the analysts, share prices are probably going to drop by a large amount. On the other hand, if it ends up surprising viewers with a lot of new features that make it the must-have phone again, this would send Apple stock soaring. The problem here is you really don’t know which way it’s going to go. There are going to be leaks and rumors but basing your trading decisions on that is probably not a good approach, often, the rumors are wrong. A strangle or straddle allows you to avoid that kind of situation and make money either way. 

The same events that might warrant buying a long call such as a GDP number or jobs report, for options on index funds, are also appropriate for strangles and straddles. 

What Is A Long Straddle? 

To set up a straddle, you buy a put option and a call option simultaneously (buy = take a long position). The maximum loss that you can incur is the sum of the cost to buy the call option plus the sum of the cost to buy the put option. This loss is incurred when you enter the trade.  

With a straddle, you buy a call option and a put option together. And they would be with the same strike price. By necessity, this means that one option is going to be in the money and one option is going to be out of the money. When approaching an earnings call, the prices can be kind of steep, because you want to price them close to the current share price. That way, it gives us some room to profit either way the stock price moves.  A maximum loss is only incurred if you hold the position to expiration. You can always choose to sell it early, if it looks like it’s not going to work out and take a loss that is less than the maximum.  

There is a total premium paid for entering into the position. This is the amount of cash paid for buying the call added to the money paid for buying the put. This is called the total premium. There are two breakeven points: 

• To the upside, the breakeven point is the strike price + total premium paid. 
• On the downside, the breakeven point is the strike price – total premium paid. 

It the price of the stock moves up past the breakeven point, the put is worthless. However, the call option would earn substantial profits. On the other hand, if the stock price moved down past the lower price point, that would be the breakeven, the call option would be worthless and the put option would earn substantial profits.  

For example, suppose that we buy a $207.5 straddle on Apple 7 days to expiration with an implied volatility of 35%, and the underlying price is $207. The total cost to enter the position is $8.03 ($803 total). At 1 day to expiration, the share price breaks up to $220 a share after the earnings call. The put expires worthless, but the call jumps to $12.50. The net profit is then $12.50 – $8.03 = $4.47, or $447 in total per contract.  

If instead, the share price had dropped to $190, the call expires worthless, and the put jumps to $17.50 per share. The net profit, in this case, is then $17.50 – $8.03 = $9.47 per share or a total of $947. 

This isn’t to say that the straddle would be more profitable for a stock decrease, it is not. The profit will be the same no matter which way the share price moves, in our examples, we used two different sized moves. The point is to illustrate that no matter which direction the stock moves, you can profit.  If the stock is at the money at expiration, we could still recoup some of the investment and sell the straddle for a loss. In this case, the call and the put would both be priced at $152. We’d still be at a loss, but we could recoup $304 by selling both at $152.  

Short Straddle 

If you sell a straddle, then you are taking the opposite position, which means you would be betting that the share price stays inside the range and hope that the stock didn’t make a big move to the upside or the downside. To sell a straddle you’d have to either be able to do a covered call and protected put or be a level 4 trader who could sell naked options. 

Long Strangle 

A strangle is similar to a straddle, but in this case, the strike prices are different. In this case, you will buy a just barely out of the money call option, while simultaneously buying a slightly out of the money put option. The two options will have the same expiration date. The breakeven points for a strangle are going to be calculated in a similar way as the breakeven prices for a straddle, but you are going to use the individual strike prices for the call and put because they are different. So, you calculate the total premium paid, which is the total amount paid for the call option plus the premium paid for the put option. Then the breakeven points are given by the following formulas: 

• To the upside, the breakeven point is the strike price of the call + total premium paid. 
• On the downside, the breakeven point is the strike price of the put – total premium paid. 

In a similar fashion as compared to a long straddle, the maximum loss is going to occur when the share price ends up in between the two strike prices. Therefore, you might want to choose strike prices that are relatively close, in order to minimize the range over which the loss can occur. Of course, there is a tradeoff here because the closer in range the strike prices are, the more expensive it is going to be in order to enter the position. But, it’s going to increase your probability of profit because if the strike prices are tight about the current share price, there is a higher probability that the share prices are going to exceed the call strike + premium paid, or decrease below the put strike price less the price paid to enter the contract the premium.