Do you want the truth about the strangle trade ahead of earnings? You probably don’t, but I am going to give it to you anyway. The truth is the strangle trade usually doesn’t work ahead of earnings.  The news gets worse; when a strangle trade fails, it is usually a spectacular and devastating failure.

Let’s review the trade. Perhaps you were taught a strangle on earnings where you buy an out-of-the-money call option and an out-of-the-money put option on a stock, essentially strangling the position. Then, when the earnings announcement was made, you were hoping the stock would spike in either direction and allow you to quickly capture the profit. I learned this as the “Chicken Trade”, and it used to work, a long, long time ago.

Unfortunately, that strategy no longer works. That’s too bad, because it was a popular strategy that a lot of people used to make money. But if you tried that today, you’d likely lose, maybe a lot.

These days  stocks can show very dramatic moves over earnings but the market makers have become proficient at pricing options in such a way that even a big move in the stock does not adversely affect  the market makers position.

Now the market maker goes into these positions weeks before earning and you see the implied volatility start to creep up. The implied volatility determines the time value of an options price. They will start to sneak that implied volatility up until it is so high that they have covered themselves from a big move, one way or the other, so they won’t have to pay out on that move.

The traditional strangle doesn’t work now because the market makers have inflated the implied volatility in such a manner that a big move in the stock price results in little or no change in the option price. A big move will result in little or no payout to the options owner over the earnings announcement. In fact, you’re very likely to lose money on a position, even though the stock shows a dramatic move.

But just because that door is closed, doesn’t mean there’s not another way to attack.

Since you know the earnings announcement is going to happen, there is a way to potentially profit by getting ahead of the announcement.

One strategy that you can still consider for earnings season is something I call the Long Vega Strangle. This is an option strategy that is directionally neutral throughout the trade. In other words, I don’t care which direction the stock moves. In fact, if it stays in the same spot from the beginning of the trade to the end of the trade, that is perfectly OK.

It is typically done when implied volatility is low and the trader expects a large move up in implied volatility.

That usually means weeks ahead of an earnings announcement. The time frame for the move is one to several weeks. The strategy allows traders to capture a large increase in implied volatility without regard to the movement of the underlying stock.

The option selection typically has a low Delta and Gamma. The option should also have some Vega. Low Gamma and Delta ensures that the option price is less sensitive to the stock’s price movement. The higher Vega ensures the option price will increase as the implied volatility goes up.

The maximum risk is only realized if the implied volatility does not move. A significant move in the stock’s price could cause the strategy to act like a Gamma strangle and would be handled as such if the stock price moves beyond one of the strike prices. (More information about the Gamma Strangle strategy is available in my Ultimate Options Trader video series and The Morning Lab.)

In this trade, you’re going to look for a position that’s far out of the money. If the stock happens to move enough to put us in the money, that’s not a bad thing.

When it comes time to enter the trade, you should find a stock that is volatile. The Average True Range over 22 days (ATR 22) should be above $5.

The stock should have a confirmed earnings announcement in the next 3-4 weeks.

Implied volatility should be near historic lows. Less than 20 is ideal, but the trade can still be successful if implied volatility is less than 30.

The Delta should be in the single digits to low teens. This will mean several strike prices out of the money for calls and puts. Typically, these options will be relatively inexpensive.

Here’s an example of a setup for a Vega Strangle:

This stock is trading for $385 a share and has an earnings announcement coming in three weeks. You buy the 430 call for $2.10, which is way out of the money and meets the other requirements. Then you buy the 330 put option for $3.10, because it also meets your requirements.

This is not a trade that should be managed until the day before expiration, unless one of the strike prices goes in the money due to stock price movement.

Allow the implied volatility to rise as earnings approach. Exit the entire trade when the trade is profitable overall. The peak profits may occur just before the earnings announcement.

If the stock moves enough to take one strike price in the money, manage the trade like a Long Gamma Strangle or consider using a strangle/spread combo.

Let’s say that right before the earning announcement, the stock has moved up to $398 per share but what’s important is to notice what has happened to the implied volatility. The IV has gone up and so has the Vega, which is the measure of how much the option price will change. This will cause the option’s “time value” to go up, potentially raising the price of the option.

The call option went up in value, even though the stock price never got in the money. The stock is still $32 out of the money. In our example, it may have gone up $2.70 more than the purchase price of the option.

Even more stunning is that the put option also went up. The put option went up even though the stock price went up. How is that possible? It happens because the implied volatility moved up and that generates the profit in the trade.

All you did in this trade was buy time value (volatility) when it was priced relatively low, knowing it had a chance to be priced at a higher level at some time in the future.

 

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