Earnings season is here, ladies and gentlemen, and with it comes heightened volatility for many stocks as investors anticipate, and react to, quarterly reports. What can savvy traders do to capitalize on volatility spikes? Today, we will break down the long strangle options strategy, and how it can help investors profit from surging volatility without committing to a bullish or bearish bias.
A long strangle involves two simultaneous options trades, one bullish and one bearish, on the same underlying stock. A call and put are both bought to open, and the options share an expiration date. This allows a trader to benefit from an equity's outsized move in either direction. While quite similar to a straddle, the one difference between a straddle and a strangle is that the strangle involves a call and a put at two different strike prices. These strike prices tend to be out-of-the-money, flanking the stock's current perch.
Let's take a look at an example. Stock XYZ takes its turn in the earnings confessional next week, and the shares have a history of making dramatic gap moves after quarterly reports. The stock currently sits at $98, so the trader initiates a long strangle by buying to open (at the same time) a weekly call at the 102-strike, and a weekly put at the 95-strike. The call is priced at $0.43 and the put is priced at $0.31, bringing the total net debit to $0.74 -- or $74, when multiplied by 100 shares per contract.
Should XYZ rise past the upper breakeven rail at $102.74 (call strike plus net debit), or fall below the lower breakeven rail at $94.26 (put strike minus net debit), by the time the options expire, the trader will profit. In our hypothetical situation, the trader is banking on a quick 4.8% rise or a 3.8% drop in the equity following XYZ's earnings release.
The worst-case scenario would be for the stock to remain relatively stagnant through expiration and expire somewhere in between the two purchased strikes, causing the trader to incur the maximum potential loss on the play (which is equal to the initial net debit of $0.74, or $74, plus any brokerage fees).
In other words, the underlying stock must make a big enough move to offset the "double premium" paid to establish the simultaneous call and put positions. In addition, because events such as earnings are a key driver of implied volatility, it's common to see option premiums inflated above "normal" levels ahead of events like earnings.
In conclusion, the long strangle is an options strategy for those with a very aggressive stock move in mind. Magnitude, not direction, is critical when entering such a trade. Remember -- the more you pay to enter the strangle, the greater the stock's post-event move must be.