How to Trade a Long Straddle When Expecting a Large Earnings Move

Key Points

• Straddle options trades are like taking an over/under sports bet on an earnings report.
• A straddle is a multi-leg options strategy that involves buying a call-and-pull option with the same strike and the same expiration for the underlying stock.
• Straddle trades are highly speculative, and profits and losses should be taken immediately following the earnings release to minimize the impact of IV crush on premiums.

Earnings season is the time when stocks make large price swings based on how the market perceives their earnings reports. Earnings reports are the most materially impactful news events for stocks. Traders, speculators, and gamblers regularly place their bets with stock options, hoping for the big price gap up or down, often taking directional out-of-the-money (OTM) call or put options like scratch-off lottery tickets. While the payoffs can seem big, most bets go bust, just as most lottery tickets lose.

While it's never a great idea to bet on earnings results, there is another way to play the outcome rather than taking a directional approach. In sports betting, the over/under bet enables you to bet on the total points scored in the game being above or below a specific number rather than on who wins. This is the same concept with a long straddle. The stock must rise above or below a specific price level for the trade to be in the money. Failing that, the straddle position loses value.

How to Execute Long Straddle Trade

To set up a straddle, first choose a strike price. Then, purchase both a call option and a put option at that same strike price and expiration date. This straightforward two-legged options strategy can be executed either manually or automatically, depending on your brokerage platform. Most platforms offer a straddle trading option, allowing you to easily select the strike price and expiration for both the call and put options.

Let's use leading AI chip stock Applied Micro Devices Inc. NASDAQ: AMD as an example.

AMD stock has fallen heading into earnings after completing the cup pattern at $187.11. The sentiment going into its earnings report is negative. The daily relative strength index (RSI) has also fallen to the oversold 30-band. 

Step 1: Select the Strike Price and Expiration

AMD is trading at $138.44. Since earnings are being reported after the close, you can select the August 2, 2024, expiration date, which is 2 days away. You will also select the $140 strike price.  

Step 2: Buy the Call and Put Options

The cost of the long AMD 140 call is $5.53. The close of the long AMD 140 put is $6.93. The total cost of the trade is $12.45. The trade is:

• Buy 1 AMD 140 Call for $5.53
• Buy 1 AMD 140 Put for $6.93

This position would cost you $12.45 or $1,245. In order to break even on the trade, AMD would have to rise to $152.45 on the upside or fall below $127.55 on the downside. This is the strike price plus the cost of the trade, $12.45. Since there will be 2 days until expiration, there will still be time to salvage some value should AMD shares stay within the $152.45 to $127.55 range if you cut losses quickly.

Step 3: Take Profits As You Make Them or Cut Losses Quickly

Depending on how far away your expiration is, you will need to take your exits quicker. The problem often is that traders may get greedy and want more money, not realizing that time is of the essence. For straddles that are under one week until expiration, you will need to lock profits or cut losses quickly.

With the AMD 140 straddle, the outcome was a gap-up the following morning. AMD surged on the open to $152.85. You needed AMD to bounce up to $152.45 to break even on the trade. However, you can see that the straddle is worth $13.59 due to the high volatility on the open. You can and should cash out at $13.59 for a profit of $1.14 on the trade.

Since AMD gapped up, the $140 put option collapsed in value to 26 cents, down from $6.93. However, the $140 call option jumped in value to $13.33, up from 5.53. The net total value of the contracts is $13.59, resulting in a $114 profit or a 9.1% return.

Straddles Plays on Earnings is a Speculative Bet

As most lottery scratch-off tickets lose, most straddles and directional options bets on earnings will lose. However, unlike lottery tickets, you can salvage some value on your options straddle if you cut your losses quickly. Keep in mind that premiums will sink immediately due to the implied volatility (IV) crush that occurs after the earnings release. In fact, you may be right on your trade but still lose money because of the IV crush, causing premiums to collapse, especially if your options are OTM.

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