The Problem With Earnings Straddle Options Strategy

Why isn't the Earnings Straddle options strategy the holy grail of options trading?

Earnings Straddle - The Holy Grail of Options Trading?

Many beginners to options trading get an ah-ha moment when they think they found the holy grail of options trading, a way to always make money no matter what happens, when they learned that they could buy BOTH call and put options at the same time! Yes, if you can profit in BOTH upwards AND downwards movements, surely it's a sure win situation, right? Especially if you do that before a stock moves strongly, like a day or two before its earnings release and then wait for the win? Wow, does that even sound legal? Sounds like free money!

Well, first of all, it is perfectly legal but what most beginners to options trading do not realise is that this is not a new discovery. It is a well known options strategy known as the "Long Straddle" and when applied before an earnings release, it is known as a "Earnings Straddle".

Earnings Straddle - Options Pricing More Than Just Stock Movement

Now, if the Earnings Straddle is the holy grail of options trading, why isn't everyone doing it and becoming gazillionaires? Well, the truth is, it is not a fail proof options strategy. In fact, its failure rate is so high that not many professional options traders engage in it. Those who does, do so with very strict criteria in terms of the kind of options that qualify (which means that it is possible but within very strict parameters).

Now, you may ask, if you could profit from BOTH up AND down movements, especially during an earnings release, what could possibly go wrong?

This is where knowledge of options pricing comes in. Stock price movement is only one of the four main direct determinants of options pricing (main, not only. There are a few more factors). Yes, options price is affected not only by movement in the stock price itself (options greek Delta), but also by implied volatility (options greek Vega), interest rates (options greek Rho) and time decay (options greek Theta). Of the four, Delta and Vega affects options prices the most, meaning the stock price movement and the implied volatility.

Learn more about options greeks.

Earnings Straddle - The Problem is Implied Volatility

Stock price movement is what options traders are trying to profit from in a straddle or earnings straddle but the problem is that implied volatilty is the main stumbling block to the profitability of this options strategy.

What implied volatility means in a nutshell is that the more the stock is expected to move, the more expensive the options, both call options and put options, become. Yes, this is how options keep things fair between trading the stock itself and the options.

If a stock is expected to move alot, like in an earnings release, the options would already build up alot of extrinsic value through implied volatility leading up to the event and become very expensive. Remember, when you buy BOTH call options and put options together, you are already paying roughly 100% more premium than if you would buy only one side of it. This is as good as saying that your breakeven point on one side of the trade is going to be 100% profit! Yes, you need a 100% profit just to breakeven on one side, thats how far the breakeven point is. Now, imagine that the breakeven isn't going to be just 100% but perhaps 200% or more due to the huge amount of extrinsic value you are paying on At The Money options (which has already the highest content of extrinsic value versus in the money or out of the money options) which is inflated by a huge amount of implied volatility.

Now, buying expensive options isn't necessarily a bad thing if not for the fact that there is a phenomena known as "Volatility Crunch" the moment earnings gets released. Volatility crunch in a nutshell means that the moment the volatility event happens, those huge pent up value created through Vega disappears all at once. Because of that, if the underlying stock doesn't move very significantly, the position would turn out to be a loser.

Indeed, there are 5 things that can possibly happen during earnings release:

1, stock moves up big.

2, stock moves up slightly.

3, stock remains unchanged.

4, stock goes down slightly.

5, stock goes down big.

Due to volatility crunch, an earnings straddle would likely turn out profitable only if the stock moves up or down big, which is only 2 out of 5 possible scenarios, a mere 40% chance of winning.

Earnings Straddle - Volatility Crunch Example Lets look at a simplistic example of how volatility crunch affects the earnings straddle. Assuming XYZ company is trading at $30. Its at the money call options with delta of 0.5 is normally trading at $1 and its at the money put options with delta of -0.5 is normally trading at $1 as well. Due to impending earnings release, the value of the call and put options have both been inflated to $2 each. As such you bought the straddle at $2 + $2 = $4. At last earnings is announced and before anything happens, the price of both call and put options returns from $2 to $1 due to volatility crunch. So you have just lost $2 on that position. Following the earnings release, XYZ stock price rise by a decent 10% to $33. The call options rise to $3 x 0.5 = $1.50 + $2.00 = $3.50 due to its 0.5 delta. The put options value drops to $0.25 (a ballpark way out of the money price). The total value of the position becomes $3.70. Howver, you paid $4 for the position so you end up with a $4 - $3.70 = $0.30 loss. This is just a simplified example of how volatility crunch work against an earnings straddle even with a 10% move on the underlying stock. Read more about volatility crunch here.

Earnings Straddle - Why Not Buy Way Ahead of Time?

So, then you might ask why don't we buy the straddle way ahead of time then? Like a few weeks before the earnings release?

Well, that is possible but what is going to happen is that the stock might move in either direction quite significantly even before earnings release, inclining your straddle to one side, making it no longer a fair weighted straddle by the time of earnings release. That means the straddle would likely only profit if the stock moved in the same direction due to the delta of the straddle being inclined in the direction that it had prior to earnings release, so you are actually not making a fair up and down bet anymore but a one sided bet more or less.

Now, since volatility builds up towards earnings release, won't we get a free ride to profit by buying the straddle a few weeks ahead of time and watch the extrinsic value increase? Well, the catch here again is that the stock price would very likely move quite significantly leading up to earnings release and the volatility build up affects at the money options more than any other options. By which time, your position may be so far out of the money that you may not stand to benefit much from any extrinsic value increase. So, again, no free money.

In fact, Goldman Sachs once ran a research on this and found that only about 56% of earnings straddles make a profit and even that, the average profit was only 2%, which is impossible to profit from after commissions most of the time.

Earnings Straddle - Conclusion

In conclusion, earnings straddle is a very real and viable options strategy but there are very specific conditions under which it can work and those conditions are usually the proprietary trading plans of those options traders that specialise in this kind of options trading. As such, Earnings Straddle is not the holy grail of options trading that many options trading dummies think it is and I hope with this tutorial, you would be better informed about this options strategy and not jump in blindly on it. If you are a beginner to options trading, you may wish to check out my Options Trading For Dummies free tutorial.