While earnings season just began, we’ve already seen a fair share of volatility from stock reporting.
For example, the other day, Netflix disappointed on its Q2 subscriber growth numbers, which crushed the stock price by nearly 11% overnight.
On the other hand, stocks in the banking sector barely moved after their earnings announcements. For example, Bank of America’s shares ended the week down a measly 0.17%.
Why am I talking about this?
Options premiums get elevated before an earnings announcement. And there is money to be made if you think the market is pricing them relatively cheap or expensive.
For example, on a normal day, Netflix might only move 2%, the market was expecting it to move 7%, but it actually moved 11%. If you had a long volatility strategy, you would have made out like a bandit.
That said, I’m going to walk you through four volatility strategies that are popular among options traders.
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What is volatility trading with options?
One of the beauties behind options trading is that you are not limited to being a directional trader.
For example, if you bought an at-the-money call, we know that to be a bullish bet, and that you’d need the underlying stock price to rise in order to profit.
And if you bought an at-the-money put, we know that to be a bearish bet, and that you’d need the underlying stock price to fall in order to profit.
That’s options 101…
However, what if you bought the at-the-money call and at-the-money-put at the same time, what would you want to see then?
Well, in this case, since you are long the put and the call, you don’t really care which direction the stock moves, you just want it to move big… like Netflix did last week.
Now, this is the straddle view of NFLX options the day before it reported earnings last week. The calls are on the left-hand side, while the puts are on the right-hand side. What we’re looking at here are the $365 strike price calls and puts.
As you can see, if you look at the row in the green box and the columns, the calls (left-hand side) were worth $13.95, while the puts (right-hand side) were worth $13.20.
When you’re long a call and a put, it’s known as a long straddle position. For example, the long straddle for Netflix was worth $27.15 ahead of earnings. That means the market was implying around a 7% move for NFLX.
Here’s a look at the risk profile for the straddle.
With the straddle, your maximum loss is limited to the premium paid. That means if you bought the straddle ahead of NFLX earnings, and the stock didn’t move a whole lot and stayed right at $365… well, you would’ve lost all the premium.
Now, there are actually two break-even points with the straddle occur at the strike price plus the total premium ($365 + $27.15) or the strike price minus the total premium ($365 – $27.15).
Well, NFLX closed at $315.10 on Friday. That means the puts expired in the money and were worth $49.90… while the puts expired worthless. Consequently, you would’ve profited over $20 on the straddle alone.
If you’re looking for a large move in either direction, then the straddle could be useful.
However, the straddle isn’t the only volatility strategy you could use. For example, the long strangle is another way to play for a large move in a stock.
Now, with the long strangle, you would buy a put at strike price A and a call at strike price B. Typically, the strike price for the put would be lower than the strike price for the calls… and the stock will be trading between strike prices A and B.
Here’s a look at the risk profile for the long strangle position.
Again, your maximum potential loss is limited to the net premium paid, and there are two break-even points, just like the straddle.
For example, you could’ve set up the strangle ahead of NFLX earnings by purchasing the $360 strike price puts and buying the $370 strike price calls. Those options were worth $10.80 and $11.79, respectively.
That said, with this strategy, similar to the straddle, you would want the stock to move in either direction a lot. More specifically, you would want the stock to move over $22.59 to be in the money.
With the NFLX trade, you could’ve sold the puts for around $45, and your profit would’ve been $22.41 ($45 – $22.59).
Now, what happens if you don’t expect a large move in either direction… and you expect the stock to trade around a specific level? Well, the long butterfly comes into play here.
Don’t Expect A Large Move? The Long Butterfly Comes into Play
Unlike the long straddle or strangle, with the long butterfly strategy, you actually want the stock to stay around a specific price at expiration.
So how would you construct this strategy?
Well, there are actually three components to the trade, and we’re going to be sticking with calls, even though you could use puts to establish the position too.
Now, you would simultaneously buy a call at strike price A, sell two calls at strike price B, and buy a call at strike price C.
Typically, when you put this strategy into place, you want the stock to be trading right around strike price B.
Here’s a look at the profit and loss (PnL) chart of the long butterfly strategy on the expiration date.
If you’re long butterflies, your risk is limited to the net premium paid. Now, with the butterfly strategy, the sweet spot is right at strike price B.
In other words, you want the stock to be exactly at that price at expiration (or very close to it if you decide to close out the position before the expiration date.
Now, there are two break-even points here. The first break-even point is strike price A plus the net premium, while the second break-even is strike price C minus the net premium paid.
Keep in mind, the long butterfly is only useful in specific situations… and being long butterflies into earnings probably isn’t your best bet.
However, if it’s after earnings and you see a stock trading right around a key level… and you expect the stock to stay around there, then the butterfly strategy may be useful.
There’s another strategy you could use if you don’t expect a large move in the underlying stock: the iron condor.
The iron condor may be tricky to implement at first if you’re just learning how to trade options.
You see, there are four components to this strategy.
You would purchase a put at strike A, sell a put at strike B, sell a call at strike C, and buy a call at strike D. Typically, you want to select the strike prices so that the current stock price will be between strike price B and strike price C.
Now, to make things simpler, you can think of this strategy as a combination of two spreads. Basically, the long put and short put create the short put spread, while the long call and short call create the short call spread.
Here’s a look at the risk profile for the iron condor.
With this strategy, you’re expecting the stock to stay within a range. Now, your maximum profit potential is limited to the net premium received (typically, you would be able to put this strategy into place for a net credit).
Now, the sweet spot here is when the stock price is between strike price B and strike price C on the expiration date.
On the other hand, the maximum potential loss is limited to strike price B minus strike price A minus the net premium received.
For example, let’s say you expected NFLX to trade between $310 and $320 after its earnings announcement… then you could’ve used the iron condor strategy.
As you can see, options allow you to still potentially profit even if you don’t know the direction. If you expect a large move, then the long straddle or strangle could be used. On the other hand, if you expect a minimal move in the stock… then the long butterfly or iron condor may be useful.
Now, if you’re struggling with finding the direction in stocks and are still uncomfortable trading… then check out my latest trading lesson on how to find clarity amongst all the chaos in the markets… however, you’ll need to hurry and secure your spot today because spots are filling up quickly.
[Ed.note: Kyle Dennis runs BiotechBreakouts.com. He is an event-based trader, who prefers low-priced and small-cap biotech stocks.
Source: BiotechBreakouts.com | Original Link