As a general rule, the price of any stock ultimately reflects the trend, or expected trend, of the earnings of the underlying company. In other words, companies that grow their earnings consistently tend to rise over time more than the stocks of companies with erratic earnings or losses. This is why so many investors pay close attention to earnings announcements.

Every quarter, U.S. companies announce their latest earnings and sales results. Sometimes, this information is entirely in line with expectations and the market basically shrugs its collective shoulders. At other times, however, a company unleashes an earnings surprise, and the stock market reacts in a decisive fashion. Sometimes, the reported results are much better than expected - a positive earnings surprise - and the stock reacts by advancing sharply in a very short period of time to bring the price of the stock back in line with its new and improved status. Likewise, if a company announces earnings and/or sales that are far worse than anticipated - a negative earnings surprise - this can result in a sharp, sudden decline in the price of the stock, as investors dump the shares in order to avoid holding onto a company now perceived to be "damaged goods".

Either scenario can offer a potentially profitable trading opportunity via the use of an option trading strategy known as the long straddle. Let's take a closer look at this strategy in action. (To learn more, read Surprising Earnings Results.)

The Mechanics of the Long Straddle
A long straddle simply involves buying a call option and a put option with the same strike price and the same expiration month. In order to use a long straddle to play an earnings announcement, you must first determine when earnings will be announced for a given stock. You might also analyze the history of the stock itself to determine whether it is typically a volatile stock and if it has previously had large reactions to earnings announcements. The more volatile the stock and the more prone it is to react strongly to an earnings announcement, the better. Assuming you find a qualified stock, the next step is to determine when the next earnings announcement is due for that company and to establish a long straddle before earnings are announced. (To learn more, read Straddle Strategy A Simple Approach To Market Neutral.)

Setting Up the Long Straddle Position

When to Enter
When setting up the long straddle, the first question to consider is when to enter the trade. Some traders will enter into a straddle four to six weeks prior to an earnings announcement with the idea that there may be some price movement in anticipation of the upcoming announcement. Others will wait until about two weeks prior to the announcement. In any event, you should generally look to establish a long straddle prior to the week before the earnings announcement. This is because quite often, the amount of time premium built into the price of the options for a stock with an impending earnings announcement will rise just prior to the announcement, as the market anticipates the potential for increased volatility once earnings are announced. As a result, options may often be less expensive (in terms of the amount of time premium built into the option prices) two to six weeks prior to an earnings announcement than they are in the last few days prior to the announcement itself.

Which Strike Price to Use
In terms of deciding which particular options to buy, there are several choices and a couple of decisions to be made. The first question here is which strike price to use. Typically, you should buy the straddle that is considered to be at the money. So, if the price of the underlying stock is $51 a share, you would buy the 50 strike price call and the 50 strike price put. If the stock was instead trading at $54 a share, you would buy the 55 strike price call and the 55 strike price put. If the stock was trading at $52.50 a share, you would choose either the 50 straddle or the 55 straddle (the 50 straddle would be preferable if by chance you had an upside bias and the 55 straddle would be preferable if you had a downside bias). Another alternative would be to enter into what is known as a strangle by buying the 55 strike price call option and the 50 strike price put option. Like a straddle, a strangle involves the simultaneous purchase of a call and put option. The difference is that with a strangle, you buy a call and a put with different strike prices. (To learn more, read Get A Strong Hold On Profit With Strangles.)

Which Expiration Month to Trade
The next decision to be made is which expiration month to trade. There are typically different expiration months available. The goal is to buy enough time for the stock to move far enough to generate a profit on the straddle without spending too much money. The ultimate goal in buying a straddle prior to an earnings announcement is for the stock to react to the announcement strongly and quickly, thus allowing the straddle trader to take a quick profit. The second-best scenario is for the stock to launch into a strong trend following the earnings announcement. However, this would require that you give the trade at least a little bit of time to work out.

Shorter-term options cost less because they have less time premium built into them than longer-term options. However, they also will experience a great deal more time decay (the amount of time premium lost each day due solely to the passage of time) and this limits the amount of time that you can hold the trade. Typically, you should not hold a straddle with options that have less than 30 days left until expiration because time decay tends to accelerate in the last month prior to expiration. Likewise, it makes sense to give yourself at least two or three weeks of time after the earnings announcement for the stock to move without getting into the last 30 days prior to expiration. (To learn more, read The Importance Of Time Value.)

For example, let's say that you plan to put on a straddle two weeks - or 14 days - prior to an earnings announcement. Let's also say that you plan to give the trade two weeks - or another 14 days - after the announcement to work out. Lastly, let's assume that you do not want to hold the straddle if there are fewer than 30 days left until expiration. If we add 14 days before plus 14 days after plus 30 days prior to expiration we get a total of 58 days. So in this case, you should look for the expiration month that has a minimum of 58 days left until expiration.

Example Trade
Let's consider a real-world example. Apollo Group (Nasdaq:APOL) was due to announce earnings after the close of trading on March 27, 2008. On February 26, a trader might have considered buying a long straddle or a long strangle in order to be positioned if the stock reacted strongly one way or the other to the earnings announcement. In this case, APOL was trading at $65.60 a share. A trader could have bought one contract each of the May 70 call at $5 and the May 60 put at $4.40. The total cost to enter this trade would be the cost of the two premiums, or $940. This represents the total risk on the trade. However, the likelihood of experiencing the maximum loss is nil because this trade will be exited shortly after the earnings announcement and thus well before the May options expire. (To learn more, read Understanding Option Pricing.)

If you look at Figure 1, you will see the price action of APOL through February 26 on the left and the "risk curves" for the May 70-60 strangle on the right. The second line from the right represents the expected profit or loss from this trade as of a few days prior to earnings. At this point in time, the worst-case scenario if the stock is unchanged is a loss of approximately $250.

Figure 1: Apollo Group stock and risk curves
Source: ProfitSource

On March 27, APOL closed at $56.34 a share. After the close on March 27, APOL announced disappointing earnings. The following day, the stock opened at $44.49 and closed at $41.21. As you can see in Figure 2, at this point, the May 70-60 strangle showed an open profit of $945.

Figure 2: Apollo gaps lower after earnings announcement; strangle shows big profit
Source: ProfitSource

So, in this example, the trader could have exited the trade one day after the earnings announcement and booked a 100% profit on investment.

In the old days, an investor or trader would analyze the prospects for the earnings of a given company and, based on that analysis, would either buy the stock (if he thought the earnings would grow) or stand aside (if he thought the earnings would be disappointing). With option trading, a trader or investor can now play an earnings announcement without having to take a side. As long as a trader has some reason to expect an earnings surprise or a stock simply has a history of reacting strongly to earnings announcements, he or she can use a long straddle or strangle to take advantage of the anticipated price movement. If the stock does indeed make a sharp price movement - in either direction - a sizable profit is possible. In addition, if the trade is properly positioned (i.e., with enough time left until expiration) and properly managed (i.e., exited reasonably soon after the earnings announcement), then the risk on the trade is typically quite small. In sum, this strategy represents one more way to use options to take advantage of unique opportunities in the stock market.

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