After big falls this past week, the market’s eyes now turn to the reporting season.
Not ours; most Australian companies reported back in August. This week, it’s the US’s turn as companies start releasing third quarter earnings.
With the stock market a bit skittish, nervous investors will be poring over results line by line.
In Australia, continuous disclosure rules mean that there shouldn’t really be any nasty surprises. The idea being that a company must release any information that could potentially move the share price either way.
Nevertheless, there are always a handful of companies that manage to surprise, incurring the wrath of their shareholders (and the ASX) in the process.
Of course, it can go the other way too. Sometimes companies just produce a magnificent set of numbers, sending the market all cock-a-hoop.
For an investor, being on the wrong side of a bad result always hurts. But for a trader it can also offer a potentially profitable trade.
A bet each way
If a trader believes a company could surprise, they could take a position before the results come out.
If they expect good news, they could buy some shares. If bad news, they could short sell shares (if they have access), or go short with CFD’s instead.
The downside being that if they get it wrong, they could really take it in the neck.
However, there is also another way to play it. It enables you to take a position in either direction. You can also set up a trade that captures a move, whichever way it goes.
And how do we do that? Through the use of options.
If you thought a share price was going to jump, you could buy a call option. A call option gives you the right to buy the underlying shares at any time until it expires.
If you get it wrong, you lose the premium you paid, which can be a fraction of buying the shares outright.
The same thing applies with put options. A put gives you the right to sell shares at any time until expiry. If you get it wrong, again you lose your premium.
Whether you buy a call or a put, though, you can still sell it back before it expires to recoup some of your money.
However, by using both together, it enables a trader to capture a move either way.
Ignore the jargon
One of the things that puts people off about options is all the jargon that comes with them. Sometimes it can sound like another language.
However, if you focus on basic ideas, options are not as confusing as you might think. No matter how weird they sound, all strategies use either a call or a put option, or a combination of the two.
If you understand what call and put options are, you can piece together even the most advanced strategies.
To capture a share move in either direction, you can use a strategy called a straddle. Again, a straddle might sound confusing. It simply involves buying a call and put option at the same strike price, with the same expiry date.
For example, if a stock is trading at $4 and you expect it to break out — but you don’t know which direction — you could buy a straddle. In this example, that means buying a call option at $4, and also buying a put option at $4.
Again, noting that they are both at the same strike price…and the same expiry.
How does it work?
At first glance, a straddle might seem like a no-brainer. After all, what’s to lose if it captures a share move either way.
The answer is your premium. Or more specifically, premiums.
Unlike buying a call or put option in isolation, you are paying for two lots of premiums when you place a straddle.
So what to straddle traders do?
If the stocks breaks out, it needs to move in either direction beyond the combined cost of both premiums (before expiry) to make any money.
However, straddle traders rarely hold a position until expiry. And that has to do with how options work.
As one option goes in-the-money (ITM), it increases in value at a greater rate than the option that goes out-of-the-money (OTM) loses value. That has to do with something called ‘delta’.
In other words, the trader will gain more on the successful option (whether a call or put) than they should lose on the option that didn’t work.
The straddle buyer can then sell the combined position as a whole. Or they can sell each leg individually.
For example, if the share price spikes, they can lock in their profit by selling their call option. The aim being that if the share price then comes off, they can try and sell their put option for a higher value.
The drawback, though, is if the share price does nothing. That is, if after results, the share price hardly moves.
When that happens, you have two lots of time decay working against you. In that case, it is often best to get out of the position as quick as you can before both options lose too much value.
Buying a straddle won’t always work. Particularly if the share price does nothing. But they can be a handy strategy to capture a strong move in either direction.
And it uses a fraction of the capital compared to buying or selling shares outright.
All the best,
Editor, Options Trader
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