The Strangle is a strategy that, when used properly, can bring very high returns. Similar to the Straddle, the Strangle is when a trader buys both out-of-the-money call and put options, anticipating a large price move after the company reports earnings. It is a neutral-based strategy, meaning that it doesn’t matter which way the stock moves, as long as it does move. Profit potential is unlimited on the upside and at full profit if the stock hits rock bottom on the put side. The strategy is a debit spread. I prefer to only use this strategy on stocks that historically and consistently make very large price moves after reporting earnings.
While the returns can be very high, this is a strategy that is not very cheap to place, although lower than the Straddle. There are numerous factors that are keys to success using this strategy:
- The stocks volatility after reporting earnings (Historical and Implied Volatility)
- The price paid to place the trade
- The Strike Prices used and Strike Price Increments
- Time-Decay and Time-Value
- Lower Share Priced Stocks
- Time of Placement
Deciding which stocks are good candidates for a Strangle can be difficult sometimes. Just because a stock moved 15% last quarter after reporting earnings doesn’t mean the same will happen the next time, and vice versa. This is why I only recommend using this strategy only with stocks you follow daily and understand how they move both pre-earnings and post-earnings. My advice to new traders to this strategy is to look at a minimum of the last four quarters to see how the stock has moved in terms of percentage post-earnings.
The Strangle is not a strategy to use with stocks that historically move little post-earnings. An example of this would be a stock like AT&T (T). You don’t want to use a Strangle on a stock that might move only $1.00 a share after reporting earnings. You will have no chance to make any money. On the other hand, stocks like TSLA, GOOGL, SNDK, YELP, and pharmaceutical companies are good candidates (I will use this strategy on pharmaceutical companies when the FDA ishttp://kevinmobrien.com/wp-admin/post-new.php set to make a decision on drug approval/denial). BETA can also be a good gauge on how a stock may move. Even with this information, repetition and practice will be your best way to learn this strategy and when to pick your spots.
The price paid to place this trade is critical to the Strangle strategy. Often, some trades are just too expensive. This is due usually to the rise in Implied Volatility and expected price movement. Some time ago, there was an author on Seeking Alpha who recommended a Strangle on Priceline (PCLN). I knew ahead of time this was going to be a disaster of a trade. First, the options were simply too expensive. Even on a Strangle, which cost less than the Straddle, this trade was going for over $35.00 a contract on each side of the trade, the calls and puts. To add to the disaster, the author was using expiration dates that expired that same week. To explain this, if the stock didn’t move about $80.00/share, it was a loser. What I though might happen did, PCLN moved minimally. Those calls and puts both got crushed. A huge loss, but even more so because there was no time left at all for it to even move towards one of the strikes. So how does one tell if an option is overpriced? Implied Volatility (IV) is a good start, but hardly all that matters. Current market conditions, the 52-week range of the stock, historical volatility, all play a role, as does time-value.
Let’s say I wanted to use a Strangle on TSLA, with October expirations and buying $260.00 calls and $245.00 puts. The trade is going for (hypothetically) $30.00 ($15.00 for each “leg”) combined to place. This would immediately give me some hesitation, even with the time-value factor on my side. The reason is the IV crush would still severely drop the value of both the calls and puts. It would take a fairly massive move after earnings to just break-even. While this is definitely possible with a stock such as TSLA, if I am paying that much to place the trade, I better be very sure it will move like that. Anything less and the trade will lose a lot of value. However, if I saw that the trade was going for $20.00 – $22.00 to place, I would be more inclined to buy a Strangle. Understanding these subtle differences will come with experience.
The strike prices chosen is very important when placing a Strangle. You do not want to use too far out-of-the-money calls and puts. The stock could make a large price move after reporting, but if you used strikes way out there it is basically buying a lottery ticket. While the cost of the trade can be substantially reduced by doing this, it also makes it more difficult to profit, as the deltas are much lower. Market makers understand this, as well. The strike prices used also must be realistic compared to what the share price currently is and what the reasonable, expected movement might be after reporting earnings. On a stock such as GOOGL, for example, if the share price is at $650.00/share currently, I do not want to be using $800.00 calls and $500.00 puts. That is much too wide apart. A more realistic Strangle would be $700.00 calls and $600.00 puts, with longer expirations, which I will go into.
Strike price increments available is something to pay very close attention to. On higher-priced stocks like GOOGL, PCLN, etc., the strike prices are in $5.00 increments. As an example, October (calls) $650.00, $655.00, $660.00/ (puts) $645.00, $640.00, $635.00. This is not such a big issue with these higher-priced stocks, but with lower-priced stocks this is a major problem. There are times where I really like the price of a specific trade, but the strike price increments available make it impossible to trade. A stock such as Boeing (BA), at $135.00/share currently, only has strike price increments of $5.00 if using month out options. Knowing how BA tends to move after reporting earnings historically, I would never use a Strangle on BA with only those strike prices, It would take too much of a move up or down to break-even, let alone profit.
Time-Decay is one aspect of this strategy that I really stress option traders to learn. Time-Value is even more important. I would never recommend for any trader to use weekly options or soon-to-be expiring options. The reason for this is the time-decay factor. After earnings are announced, the Implied Volatility drop will always be significant. This is why you will sometimes see a stock move exactly as you hoped for post-earnings release, but the option value remains stagnant or loses value. I get asked this question all the time. Often, it was because the trader used weekly options. This is even more pronounced with the Strangle, as you are initially buying out-of-the-money options. The Straddle will have a higher delta as it is more deep-in-the-money (as compared to the Strangle). My advice: never use weekly or short-term expiring options when placing a Strangle. I recommend at least three (3) weeks of time-value. This also protects you in case the stock initially does not make the required move. If you have weekly options, you aren’t even giving the stock a chance to do so. While you will pay more for the added time-value, it is well worth it. The cost is higher, but it is a nice safety net, and the longer-term options will hold their value much better.
Always pay attention to liquidity when placing a Strangle, both the open interest, daily, and the stock itself. A great example of this is a stock like Autozone (AZO) and Intuitive Surgical (ISRG). What happens here is that the bid/ask prices are so wide on the options post earnings that even if the stock required the necessary price move to profit, you may not make what you thought you would. Often, you will not get your sell-to-close order filled at the mid-point of the bid/ask, which should be the reasonable price to close out the profitable side. Depending on the liquidity, there just may not be enough buyers willing to pay that., so the trade could sit in the queue for hours, if not days to get your desired price. I’ve seen this happen all too often. The last thing you want to see if a great trade go bad and the stock reverse itself. That’s not fun to watch.
With stocks that have a lower share price, you really have to be careful using a Strangle strategy. This is because the stock will not move as much incrementally as a stock that is higher priced, and the strike prices available may hinder any profitability. For example, if a stock is currently $20.00/share, but there are only $2.50 strike price increments available, it makes it very difficult to profit. There are exceptions to this rule, but generally, try to use stocks that are at least $50.00 a share or higher. I recommend completely staying away from stocks that are under $15.00/share.
The Strangle is very reliant on where the current share price is and when you place the trade. The goal here is to use strike price increments that are as close to neutral as possible. Placing a Strangle too early can have serious consequences. As an example, let’s say I bought a Strangle on XYZ stock at the market open when it was $100.00/share.The company is expected to announce earnings after the bell that same day. Since everyone knows this, the volume will be higher and the share price will fluctuate. By 2:00 p.m. EST that same day, the share price is now $105.00. Well, now my Strangle trade is no longer neutral-based at all. It is completely bullish to the call side. If the call side is up (which it would be under this circumstance), the put side will be down a lot, as well. Yes, you could ride it out and keep both sides, but defeats the purpose of the strategy to begin with. There is just a likelihood that the stock moves back down after-hours and into the next day that you are stuck right in the middle, which is the worst possible scenario when using a Strangle.
What I like to do is this: if a company is reporting earnings before the markets open the following day, I will place the Strangle anywhere from 2:00 pm EST- to 3:00 pm EST the day before. This allows me to have a good idea where the share price will close at and what strike prices to use to be as neutral as possible. You do not want uneven strike prices. It doesn’t have to be aligned perfectly, but as even as possible.
To summarize, while the Strangle strategy can be used to great effect, a trader must be very careful when using it. It is one of the more expensive earnings trades and while it can provide great returns when right, the losses can be very large if the stock does not move as necessary. It is a strategy that becomes more easy to understand and use properly with experience. Make sure to only use this strategy with stocks you are familiar with, and pay extra for the added time-value.
If you have any questions, please leave a comment or e-mail me at firstname.lastname@example.org. Thanks.