GMCR EARNINGS TRADE – STRADDLE PLAY
Earnings season is upon us, and publicly traded companies will be reporting their earnings for the past quarter. Earnings announcement season is a much anticipated and recurring occurrence every quarter, and options trading around earnings announcements can be both predictable and profitable for savvy options traders. Hence, I thought it only appropriate to review one of the strategies used by options traders attempting to make money with earnings announcements.
Of the many options trading strategies, the straddle is often sought by many as a way to make money irrespective of market direction. However, many newbie traders learn the finer nuances of straddle trading only after losing money. To examine how one can make money (or lose money) with a straddle, I chose to examine the behavior of an at-the-money (ATM) straddle on a popular stock – Green Mountain Coffee Roasters (GMCR). Why GMCR, you ask? It will be apparent in a moment.
CHOOSING THE RIGHT STOCK FOR A STRADDLE PLAY
A straddle is a direction-indifferent strategy that makes money if the stock moves dramatically in either direction or if the implied volatility rises. Hence, to make money one ideally would like to buy a straddle when implied volatility is low and begins to rise, and before the stock begins to move either up or down.
CHOOSING THE RIGHT TIME FOR A STRADDLE PLAY
A straddle involves the purchase of both a call and a put option, and, hence, is theta-intensive. This means that one loses money from theta decay every day that the stock does not move. Earnings season is a great time to buy a straddle, as the anticipation of earnings (whether good or bad) often causes the stock rise or fall and causes implied volatility to rise.
Generally, implied volatility rises dramatically in the 2 to 3 weeks before the earnings announcement, and usually collapses the day following the earnings announcement (if earnings announcement is after market hours) or on the day of the earnings (if the earnings announcement is before the market open). With some stocks, implied volatility and/or price movement is most dramatic in the last 1 or 2 days.
CHOOSING GMCR FOR AN EARNINGS STRADDLE PLAY
Since the effects of theta can negate the benefits of both volatility and direction, it is crucial to pick the right stock for an earnings straddle play.
To pick a stock to analyze for an earnings straddle play, I evaluated my list of highly liquid stocks with highly liquid options for the increases in ATM implied volatility in 20 days before the earnings announcements.
For earnings announcements since Jan 2012, GMCR options had an average of 120% increase in ATM implied volatility. Hence, GMCR; other considerations could be LNKD (121%) or DDD (129%).
BUILDING THE GMCR EARNINGS STRADDLE
To evaluate the effect of an increase in implied volatility with the least impact of theta, I considered a one call-one put ATM straddle purchased one day before the earnings announcement, and held for only one day. Since GMCR announces earnings after market close, data used for analysis were historical option quotes from end of day data of the day before to the day of the earnings announcement (see Table).
To evaluate the effects of theta on profits of an earnings straddle play, I considered a similar one call-one put ATM straddle initiated 20 days before the earnings announcement, and held until the day of the announcement (see Table). All data are mid-bid-ask quotes and do not include commissions.
One day to profits with a GMCR Earnings Straddle
ANALYZING HISTORICAL GMCR EARNINGS STRADDLE RESULTS
The following observations are being made with the caveat that the above GMCR straddle play is not a trade recommendation and GMCR is merely being used to illustrate and explain the nuances of how an earnings straddle play works.
- The effects of theta on profits were minimal when the straddle was held for 1 vs. 20 days.
- The increase in implied volatility in the final day prior to earnings was sufficient to generate a profit almost comparable to holding for a longer period of time.
- Conversely, holding the straddle for a longer time resulted in lower profits but increased risk – the annualized return on risk (AROR) is a calculation to help compare the equivalent ROR per year given that the two trades were held for different periods of time. In actual trading, this is an unfair number to report.
- In an effort to minimize the effects of theta, I chose option strikes with more than 30 days to expiration; hence, the effects of implied volatility would be lower as most of the changes in implied volatility are seen in the near-term options.
- While not shown in the above table, holding the straddle after the earnings announcement was associated with the risk of loss due to a fall in implied volatility, unless the stock moved dramatically to overcome the effects of the loss premium due to the fall in implied volatility.
Of course, greater profits might be obtained by choosing to a similar strategy on a stock that both moves dramatically in price as well as increases in implied volatility.
Happy Trading!
JonLuc
