How to Trade Options Around Earnings Using Straddles and Strangles

The beauty of options trading is that you don’t always need to pick a direction — even when it comes to binary events like earnings reports.

And since event-driven options trades are an important part of the Options in Play newsletter, I regularly use nondirectional strategies like strangles and straddles.

The Basics of Going Long Volatility Via Strangles and Straddles 

Essentially, I’m looking for situations where the options are underpricing a potential move.A long strangle entails involves going long call and put options on a stock or other security. The calls and puts have identical strike price and expirations.

Going long a strangle means you are long volatility, since you want higher volatility. This is because higher volatility increases the value of options.And on the flipside, a short strangle means you are short volatility, because lower volatility decreases the value of options.

The straddle is a closely related strategy.

A straddle is similar to a strangle, but uses different strike prices.I most commonly use these strategies during earnings season and on other binary events like Fed announcements, economic data reports, etc.

So let’s go through my screening process so you can start using these strategies on your own, or at least build up your options knowledge. I’ll go through the elements one by one.

Keep in mind they’re not necessarily listed in order of importance. I just want you to see how the pieces come together.

Step 1: Look for Consistent Post-Earnings Stock Price Movements

When looking at a company ahead of its next earnings report, I want to see some consistency in the past 2-3 reports.

How much did the stock move from top to bottom in terms of overall magnitude? That's what you want to know.

The absolute size of the moves is far more important than the direction.

I generally measure this in terms of points, though you could use percentages.

So, we can measure the movement from the close before earnings to the range of the following day.

I like to see an accelerating size of movement. If a stock typically swings 5 points on a normal day, I want to see it accelerating to 10+ after earnings.

Step 2: Watch the Technical Picture

This might not be the first thing that comes to mind with options, but technicals really matter with these setups.

I want to see consolidations near significant levels of support and resistance.

Why?

Because these are price points that can really trigger the the breakouts or breakdowns, and lead to what I call the Earnings Combo move.

The Earnings Combo happens when an earnings move triggers a second move — a consolidation breakout or breakdown.That’s why I’m constantly screening for consolidation gaps.

For example, I look at 52-week highs or lows, or multi-year resistance or support.

These types of charts are always on my radar in earnings season, and they factor into whether a trade sets up for a volatility strategy.

On the opposite side, what if a stock has a huge rally or drop into earnings, or is in the middle of a long-term trend?

I don’t like those setups as much because that means  expectations have gotten too one-sided.

Because of that, post-earnings volatility might be low because the news is priced in.

So watch out for big moves or trends into earnings.

Step 3: Get the Options Prices Right

Of course, the options prices matter. Because after you look at the post-earnings moves from the past 2-4 quarters and examine the technical picture, you must make sure you don’t overpay for your options.

How does the priced in move this quarter compare to the 2-3 quarter average move?

Are the options accounting for the technical picture?Are the options accounting for any major current stock-specific or market-specific headlines?

These are the types of question you have to ask.

If the options prices are in-line with the recent averages, then the technical picture must be very compelling to see “Earnings Combo” potential.

If the options prices are above average, then a large moving is being priced in, and going long the options may offer a poor-risk reward.

But if the options prices are below average, even an average post-earnings stock move can result in a nice profit on the options.

Example: Foot Locker (FL)

Look at this chart of FL:

The earnings reactions are in circles, and are consistently around 8.25 points.

And going into the next report, the stock was in a relatively tight consolidation right at key support, with well defined gaps above and below.

And here’s where things get interesting.

Going into earnings, the straddle was pricing in an approximate 5-point move — even though the stock moved 8+ points in the prior reports.This indicated that getting long volatility via a long straddle made sense.

Foot Locker missed on earnings, and then dropped about 9 points before closing down 8 points.

And since the stock moved more than what the options priced in, the straddled paid off big!You often hear “buy low, sell high” when it comes to stocks — but the same is true for volatility.

And you just saw why!