By Josip Causic, Online Trading Academy Options Instructor
A few years ago, placing a strangle or a straddle on the optionable stocks prior to their earnings was "the way to go." In this article, I will point out that the times have changed and that placing a "sure thing strategy" is no longer a sure thing.
Recently, I taught an option class in Seattle and the earnings season for the first quarter was in full swing. Some of my Seattle options students were dedicated AAPL (Apple) traders, so we looked at the possibility of placing a paper trade on it. Once again, this was done for educational purposes only and it was not intended to be any recommendation or suggestion.
For the sole purpose of instruction, I have presented two option strategies: Straddle and Strangle.
Prior to my discussion of the specifics, I must briefly run over the basic differences and similarities of the two. Figure 1 presents those facts in a visual manner.
Strategy Name |
Straddle |
Strangle |
Option Class (calls or puts) |
Different (Both + C & + P) |
Different (Both + C & + P) |
Months |
Same |
Same |
Strike |
Same |
Different |
Figure 1
For those readers who are unfamiliar with these two strategies, I will explain Figure 1.
Basically, I utilized three criteria: option class, expiry month, as well as expiry strike price. A straddle involves simultaneous purchase of a call and put on the same underlying, for the same month at the same strike price. Both calls and puts are usually ATM (at the money). By the way, those premiums are usually the most expensive ones. A strangle, unlike a straddle, involves the selection of different strike prices for the calls and puts, while the expiration month remains the same as well as the underlying.
Having explained the basics, I am going to move to the specifics. Prior to AAPL's earnings release, I have run the following calculation for the straddle:
Straddle on AAPL @ 121.53
Remember that both the call and put in a straddle are ATM, but in reality, one will be slightly OTM (out of the money) and one slightly ITM (in the money) depending upon where the stock price is compared to the strike prices.
First Leg: Call Side
BTO + 1 May 120c ATM @ 7.20 (- $720 goes out of our account)
121.53 – 120c = 1.53 of intrinsic value. Therefore, out of the premium of 7.20 only 1.53 is pure intrinsic value, while the rest of it is not. This by itself indicates that the premiums are overpriced. The extrinsic value of the May 120c equals (7.20 – 1.53) 5.67. By the way, the extrinsic value includes both time and volatility. Implied volatility at the time of this exercise was high which was reflected in the over-inflated option premiums for both calls and puts. Once again, 7.20 – 1.53 = 5.67 of non-intrinsic value.
Second Leg: Put Side
BTO + 1 May 120p OTM @ 5.45 (- $545 goes out of our account)
Unlike the call side on which we had some intrinsic value, because the 120c was ATM, on the put side, the 120p is completely OTM (out of the money) due to the fact that the price was at 121.53. Hence, buying the 120p on AAPL while the price was at 121.53 meant that all of the premium, namely 5.45 was all extrinsic value.
The cost of both legs
Having entered both trades simultaneously, the total cost was $1,265 or 5.45 for the put and 7.20 for the call. Only one contract is calculated in this example. Out of the paid premium of 12.65, there was huge intrinsic value which became of the utmost importance. In the example of a straddle, two extrinsic value amounts had to be defeated 5.45 + 5.67 = 11.11 which means that either the call or the put must be worth 12.65 just to break even on our straddle. The earnings release numbers had to be either awful so that AAPL tanks, or super good so that AAPL takes off to the moon. I personally did not expect any of these scenarios to be the case; therefore, I proceeded to the calculation of the second option strategy – a strangle.
Once again, the specifics are listed below, and the reason for the slightly different price is that AAPL moved during the time I was working out the calculation and explaining the strategy to my students. We looked at two possible strangle scenarios and collectively selected one according to the bias of the majority in class. The two possibilities involved: 1) call ATM and put OTM, or 2) the other way around. The class chose the first case scenario and its specifics are below:
Strangle on AAPL@ 121.79
Remember that normally the put and call in a strangle are both placed on the first strike OTM from the stock price, the call strike just above the stock price and the put strike just below the stock price. In this case, the class was biased to the upside so we placed the call just ITM.
First Leg: Call Side
The only difference in the presentation of the facts for the strangle versus the straddle is the inclusion of the delta [D] – presented here with the number in brackets. The delta represents three different things for option traders: hedge, the probability of expiry ITM, as well as the best known delta meaning, the change of option premium for a one point move of the underlying. When buying the call with a .58 delta then there is only a 58% chance of expiring ITM. On the put side, the selected 115p had a delta of .28 meaning that there was only a 28% chance of that particular option ending up in the money. Of course the question always remains by how much in the money.
BTO + 1 May 120c ATM [.58D] @ 7.25 (- $725 out of our account)
121.79 – 120c = 1.79 is the intrinsic value while the extrinsic value, which includes both time and volatility, is the rest of it. Namely, 7.25 – 1.79 = 5.46
Second Leg: Put Side
BTO + 1 May 115p two steps OTM [.28D]@ 3.50 (- $350)
Just observe this concept; AAPL was at 121.79 and the 115p was purchased, which is so many points away from the 121.79 stock price. The extrinsic value of 3.50 is 100% of the premium.
The cost of both legs
The total cost of strangle would be $1,075 and once again there would be two time extrinsic value amounts that had to be conquered: 5.46 + 3.50 = 8.96. In other words, at the expiry, if we were to hold it until then, which I would never suggest to anyone to do, either the call or the put must be worth 10.75 just to break even on the strangle.
For instance, AAPL would have to drop from its current price of 121.79 to 104 (OTM 115p - 11 points drop) so that the 115 put could increase in value just slightly above the break even point. Is it realistic to expect AAPL to go from 121.79 to 104?
Having looked at the put side, let's look on the call side and see what the outcome could look like. Once again, a move of nearly 11 points is needed just to break even on our strangle. Is it possible for the stock that is worth 120 to go up 12 points? This 12 point move would be equal to a 10% move of the underlying.
Next, let us compare both sides to see which side is most likely to win, if AAPL moves big. On the call side, a 12-point move could bring us to the break even point. Whereas, on the put side even if there is a 12-point move, that still would not cut it. The 115p which was purchased was almost 7 points away from the current price of 121.79 and on top of that AAPL would have to go down an additional 11 points, bringing it down to 104, just to break even. In short, the put side is unlikely to be a winner. Figure 2 presents the facts that are working against the strangle on AAPL even if the AAPL moves higher.
|
Price |
Volatility |
Time Decay |
Calls |
Goes in our favor |
Goes against us |
Goes against us |
Puts |
Goes against us |
Goes against us |
Goes against us |
Figure 2
At this point, I would like to suggest to the readers who are a bit rusty on the basic concept of options to refer to my article Triple 3 Dimensional Options Are... for a better grasp of the facts in Figure 2. There were too many factors working against the profitability of strangle.
Figure 3
The chart above shows what AAPL did after the E.R. (earnings release) came out. It hardly moved to the upside. I am glad that we did the calculation ahead of time for the underlying and concluded that AAPL most likely would not move enough to pay off the cost of both calls and puts. Additionally, the volatility for AAPL had completely gone out of the options' premiums on both ends as soon as the earnings were out. Even though our calculations were somewhat imperfect estimates, they showed that placing the straddle or strangle would have been a terrible mistake.
In conclusion, doing a straddle or strangle with the front month options when the implied volatility is extremely high is not a HPT (high probability trade). At Online Trading Academy, we teach that when the implied volatility is high, our students should be the premium sellers. Buying the directional calls and puts during high I.V. (implied volatility) is an unlikely trade. It might have worked well in the past, but that is no longer the case. Good trading.
- Josip Causic
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