The right strategy at the right time

04/27/21
  • CLX in three-week trading range, with earnings due on Friday
  • Breakout scenario offers lesson in strangles/straddles
  • “Non-directional” trades sometimes face unique challenges

For some people, one of the most appealing aspects of options is the ability to construct “non-directional” trades with the potential to profit if the underlying market goes up or down.

Aside from the reality that such trades often simply swap out a bet on the direction of price for a bet on the direction of implied volatility, there’s another challenge traders considering strategies like long straddles and strangles should understand.

A stock due to release earnings this week helps illustrate why. Clorox (CLX), which is set to post its numbers on Friday (April 30), has been in a trading range the past few weeks since pulling back from its January highs—which, as the weekly inset shows, was part of the larger retreat from its August 2020 all-time high:

Chart 1: Clorox (CLX), 1/19/21–4/26/21. Clorox (CLX) price chart. In range prior to earnings.

Source: Power E*TRADE


A trader who thought earnings had the potential to break the stock out of its consolidation—but was unsure about the direction—may consider a long strangle position, which combines a long call option with a strike price above the current stock price with a long put with a strike price below the current stock price.

No matter which way the stock moves, at least one of the options in a strangle will expire worthless--and both could, if the stock continues to trade between the two strike prices. But the more the stock moves, higher or lower, the more profitable the winning option will be:

Chart 2: Long strangle profile. Overcoming cost of options.

Source: Power E*TRADE


The two vertical dashed lines represent the strike prices of the two options. Notice that it’s not enough for the stock to just rally above the call’s strike price or fall below the put’s strike, it has to exceed either by the combined cost of the two options. Depending on current volatility levels and how far out of the money the options are, this can be a considerable hurdle—especially since both options will be fighting time decay ("theta") throughout the lifetime of the trade.

In other words, traders who use long strangles need to have a reason to believe the underlying stock has a chance of moving enough—before expiration—to overcome this hurdle by expiration. While earnings surprises can sometimes provide that volatility, there’s certainly no guarantee, and every situation is different. But there are tools traders can use to get a better idea of what’s possible. For example, the following chart shows CLX’s earnings-day trading history dating back to the third quarter of 2018:

Chart 3: Clorox (CLX) earnings history. Avg. earnings move of +/-3.36%

Source: Power E*TRADE


Clorox’s average earnings-day move has been +/-3.36% (yellow dashed line). Only five of those (represented by the green or red columns) have been bigger than 5%, while eight have been smaller than 3%.

Let’s say a trader bought a CLX May $185–$195 strangle (long the May $195 call and long the May $185 put) expecting the stock to push out of its consolidation after earnings. A realistic expectation? Well, yesterday that position would have cost around 6.30, which means the stock would have to move more than 6.30 above the upper strike ($201.30 or higher) or below the lower strike ($178.70 or lower) to become profitable.

Now let’s say CLX closed near the middle of its trading range (around $190) the day before earnings. That would mean the stock would have to rally or sell off 6% or more after earnings—something it’s done only three times over the past 19 quarters—just to get the long strangle to its approximate breakeven point.

Of course, the move doesn’t have to occur in a single day, but because of time decay, and the fact that implied volatility tends to decline after earnings (which lowers options prices), this type of position will be fighting a steeper uphill battle the longer it remains open.

The lesson: Don’t use a trading strategy because of its hypothetical advantages—use it because there’s evidence it’s appropriate for a particular situation.

Market Mover Update: With earnings due out on Thursday, First Solar (FSLR) rallied to a nine-week high on $91 Monday (see “Clouds part for solar stocks on Earth Day”). The stock’s average earnings day move is +/-8.2%.

Today’s numbers include (all times ET): S&P Case-Shiller Home Price Index (9 a.m.), FHFA House Price Index (9 a.m.), Consumer Confidence (10 a.m.).

Today’s earnings include: Alphabet (GOOGL), Eli Lilly (LLY), Advanced Micro Devices (AMD), General Electric (GE), Starbucks (SBUX), Raytheon (RTX), Microsoft (MSFT), Waste Management (WM), Visa (V), Pinterest (PINS).

 

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