What Are Earnings Strangles?
Day trading is a constant struggle to maximize gains and minimize losses. This results in maneuvers like earnings strangles. An earnings strangle is an attempt to capitalize on a company’s upcoming earnings report with a strategy that will profit from the stock’s expected movement—whether up or down.
The maneuver consists of setting both calls and puts on the same company with the same expiration date—usually the day or two after the earnings report. The strangle comes from the different prices of the puts and calls. An “out-of-the-money” call paired with an “out-of-the-money” put caps unrealized losses and lays down a runway for big gains.
Here’s How Earnings Strangles Work
Let’s say a company is set to release its earnings next Tuesday. Right now, the stock trades at an even $100. You decide to create an earnings strangle by opening the following positions:
- Calls at $102, expiring next week Wednesday, for $2
- Puts at $98, expiring next week Wednesday. For $2
This effectively creates the strangle—in this case, a $4 strangle (difference of the call plus the put). Without knowing how the company will report its earnings, you’ve created a situation where you make money in either case. Let’s look at the outcome scenarios.
Best-case scenario is that this company’s stock rises above $102. The puts expire worthless because the stock rose and you can exit the position with the gains from the call. In the opposite situation, you’re still able to make money from the earnings strangle of the price calls, so long as it falls enough to cover your puts.
What happens if the price stays flat? This is where the risk comes in. If the company’s earnings report only bumps it to $101, you’ll end up holding the bag. This is why the size of the strangle matters. Smaller strangle, less risk; larger strangle, more risk.
Volatility Can Benefit Traders
Stocks move aggressively during earnings season. This is why many traders deploy earnings strangles specifically when a company is due to report. Because investors tend to react favorably to better-than-expected earnings and overreact to worse-than-expected reports, traders can capitalize on movement in either direction with an earnings strangle.
The key to making money on an earnings strangle is to make an accurate prediction of the price movement, while paying a small premium to guard against losses. The example above balanced puts and calls. More aggressive traders would lean into larger puts or calls depending on sentiment. Then, they’d place a smaller put or call as a stopgap measure.
Why Play an Earnings Strangle?
For most stocks, an earnings report is the single biggest mover for the price. That is, of course, barring any catastrophic news or major unexpected windfalls. This works to the advantage of traders who can eliminate time as a variable.
Options only need to last through the day after the report, and there’s no need to guess on timing. This is also useful in capital allocation. You know far in advance when companies report earnings, which allows you to get into or out of positions in time to free up capital.
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The major advantage to earnings strangles is the ability to control risk based on put and call levels. Playing both sides of the report means the only variable you need to concern yourself with is magnitude. So long as the price movement exceeds your put or call levels, you’ll make money. It’s a great strategy for novice traders and those who strive to hedge whenever possible.