On-screen text: Long Strangle. KEYS. ROST.
Narrator: Earnings announcements are a popular time to trade options because the uncertainty leading up to the event can inflate options premiums. One strategy that traders can use to go long this rise in implied volatility is the strangle. But it's one thing to understand this strategy in theory, and another to see it in practice. To show how it could actually play out, I've placed a couple of long strangles on Keysight Technologies (KEYS) and Ross Stores (ROST) using thinkorswim® paperMoney®. paperMoney allows you to place trades in realistic market conditions without risking real money.
On-screen text: Tradecraft
Narrator: Keep in mind that this simulated performance in paperMoney does not ensure the same performance in a live trading environment.
I'll talk through the decisions I made to set up the trades, and then show you how I manage the trades over time. And then, I'll discuss some important takeaways after closing the trades.
Now, keep in mind that a long strangle is an advanced strategy that involves greater and more complex risks than basic options strategies. This video is intended for options traders with some experience, so if you're new to options, consider watching some of our more basic videos first. And, like all our videos, this is for educational purposes only and should not be considered individualized advice or a recommendation.
Animation: A hypothetical stock chart changes to two dotted lines. One line moves higher and the lower. A hypothetical Options Premium price tag increases in value.
Narrator: The long strangle involves buying an out-of-the-money call and an out-of-the-money put. Combining a call and a put gives a more neutral bias on the price of the underlying stock—a big move in either direction could be profitable. However, a large price move isn't required for this strategy to succeed: if the stock stays sideways but implied volatility increases, the two long options should increase in value.
I think it helps to visualize this, let's look at an example using the Risk Profile tool on the thinkorswim paperMoney platform.
Animation: The Risk Profile tool is shown. A blue line representing the expiration profile has a long downward slope from the $101 to $109 price points. Then it's flat from $109 to $112. Finally, it has an upward slope from $112 to $120. The profile shows profitability when the price is below $107 or above about $114.50. A pink line representing the current risk profile has a similar shape but is not as deep. The entirety of the current curve is above the breakeven line.
Narrator: Here's a risk profile of a long strangle, which typically profits from a drastic price move up or down. Normally, max loss occurs if the stock's price stays within the strike prices. Notice how profitability rises the further the stock moves away from the strikes. However, watch what happens to the current, or pink, risk profile when I increase implied volatility.
To do this, I'm going to click on the gear icon near the contracts. Then I'll hold the up arrow for implied volatility. Look. Do you see how the entire curve moves higher as volatility rises? When the curve rises higher, the potential profitability of the trade increases across the board.
On-screen text: The P/L Open has increased to $105.25.
Narrator: Now, look at the P/L Open for the middle price slice. I'm going to set volatility back to zero, and then jack it up again.
In this example, it takes about a tenth of a percentage point of volatility to breakeven as of today, and 12.6 points to double the value of the trade. Time decay is still an issue because it could melt faster than implied volatility may rise if the expiration is too close.
Animation: The Add Simulated Trades tab shows the options chain with columns for delta, gamma, theta, vega, bid, and ask. The vega columns are highlighted.
Narrator: If I go to the Add Simulated Trades tab, I can see the greeks listed in the options chain. Take a look at the vega column. Notice vega is higher near the at-the-money options. If the stock stays between the strikes, the trade needs higher implied volatility to be profitable.
Now that I've explained how the trade works, I'll pull up trades that I already set up. Remember that these are examples and not recommendations.
Animation: Chart of Keysight Technologies showing the price and implied volatility over time. Horizontal lines are drawn at $160 and $155.
Narrator: I'll start with KEYS. You can see from the chart that as earnings approached, Keysight had been mostly moving sideways, but had some big swings. The stock moved lower, below $160, which had been a level of support and resistance at times. There was also potential support around the $155 level.
Animation: White transparent columns are placed on the implied volatility indicator highlight changes in implied volatility around earnings announcements.
Narrator: When I placed the trade, the KEYS earnings announcement was 10 days away and the implied volatility graph below the price chart was showing the rise. Looking at past earnings announcements, we can see other implied volatility spikes ahead of many of the previous earnings reports. Of course, past performance doesn't guarantee future performance.
I chose the 18 August 23 expiration because the options closest to expiration tend to have the largest increase in implied volatility. Look at the volatility percentages for the expirations. The 18 AUG 23 expiration is at 54.49%. The 15 SEP 23 expiration is 31.84% and then they get lower the further away from expiration. Some traders may look at the longer expirations and be attracted by higher vega and lower theta, but those expirations are less likely to get a shot from earnings-related implied volatility spikes.
With KEYS trading around $157, I chose the 160 call and the 155 put, which were about equidistant from the current price. Usually, a strangle is made up of two long options that are about the same distance from the stock's price because the contracts are similar in cost, value, and implied volatility. Plus, those strikes lined up with resistance and support levels I identified on the chart. If implied volatility is the major factor driving this trade, the stock price will need to stay around the strikes. But, if price movement is the driver, then the support or resistance level needs to be broken.
When planning any trade, you need to know your exits. In this case, I planned to close the trade before the earnings announcement when I think implied volatility will be at its peak. Holding longer could get the trade caught in the volatility collapse, when much of the implied volatility goes away after the news. Even if the stock moved a lot in one direction, the volatility collapse could offset potential gains or, even worse, become a loss.
With my plan set, I placed the trade on August 8. The total cost for both contracts was $7.80, which means my max loss is $780 not including commissions and fees.
Animation: A chart of Ross Stores is on screen with the price and implied volatility over time. A horizontal line is drawn at $115. Columns are added around past earnings announcements to highlight changes in the price and implied volatility. Another line is drawn on the price chart at $110.
Narrator: I also placed a long strangle on Ross. The chart for ROST was basically sideways, which is fine if implied volatility rises. According to the chart, volatility was on the rise, so I was hoping that trend would continue. Additionally, volatility has spiked ahead of many of the past earnings reports. But again, what has happened in the past doesn't guarantee it will happen in the future.
I chose the same 18 AUG 23 expiration. The stock was trading around $112.50, which meant the 115 call and the 110 put are about the same distance from the price of the stock to get similar contract features. This trade has a combined premium of $5.07, or $507. This is the max loss for the trade not including commissions and fees. I'll need some movement in volatility or price.
Just like KEYS, I planned to close this trade before the earnings announcement to avoid the collapse in implied volatility. So I placed the trade for the 115-110 strangle.
On-screen text:3 days later (6 days until earnings)
Narrator: Now, I'm back three days later, so I'll look at the strangles. The KEYS trade is up $5 and ROST is up $2.50. Maybe not what I was hoping for, but they're positive.
Going to a chart of KEYS, the stock has pulled back a little and, unfortunately, implied volatility is pulling back too. However, we've still got time and I think the closer we get to earnings, that will turn around.
Moving over to Ross, the stock tested resistance but pulled back as well. Implied volatility is also pulling back too. Again, I'm expecting volatility will rise the closer we get to expiration, so I'll give it some time.
Let's check back in in a few days.
On-screen text: 4 days later (2 days until earnings)
Animation: The screen changes to the Monitor tab of the thinkorswim papermoney platform. Both trades are open.
Narrator: Alright, here we are again four days later. Currently, the strangles are split. Overall, the KEYS strangle is up a little more than $12 because the put is offsetting the losses on the call. However, ROST is showing losses on both contracts. Let's look at the charts to see why.
Looking at the chart for KEYS, we may still get some downside movement. The previous day's candle shows how the price fell, filled May's price gap, and then rallied back above support. The bulls are struggling to hold the line, so we may get a good bearish move that could help our strangle. Another nice thing if I get a bearish move is that implied volatility tends to rise when prices fall because bearish moves tend to be more volatile than bullish moves. So, I'll keep the trade on and see what happens.
Now, I'll pull up ROST. It's still going sideways, and resistance seems to be holding. Implied volatility is still falling, which is bad and may be a big reason why both contracts are negative. It could be that investors aren't particularly worried about Ross's report, so volatility is declining. But if I go back to the chart, I see volatility can still surge the day ahead of the earnings report. Because earnings is tomorrow, I'm going to stay in the trade.
On-screen text: 2 days later (Earnings day)
Narrator: Okay, we're back and it's earnings day for both companies. They'll report after the market closes. Let's check on the trades.
Animation: A chart of Keysight Technologies appears. The falling price and rising implied volatility are highlighted.
Narrator: Keysight is lower again today, which should boost the put. Rising volatility may have helped both contracts because there was a pretty good jump today.
On-screen text: The screen goes back to the Monitor tab and focuses on the Keysight trade.
Narrator: Let's look at the numbers.
The long strangle on KEYS has a net profit of $152.50. The call is down $187.50 but that's about $5 higher than yesterday. Today's rise in implied volatility, due to the stock price falling, helped to trim this loss. The put side of this strangle is driving the success of the trade. Falling prices accompanied by rising implied volatility, boosted the put's value, which is up $340 overall.
Remember, the plan was to close the trade before the earnings report to avoid the volatility crush. So, I'll create a closing order for a profit and then hit Confirm and Send.
Animation: A chart Ross Stores appears. The screen is zoomed in on the falling price and rising implied volatility.
Narrator: Now, let's look at Ross. The stock dropped today, which brought the price back between the 115 and 110 strikes. Implied volatility is a little higher as well, which may have helped the trade. I'll go back to the Monitor tab and check it out.
The call was up more than $62 on the previous day but, today, is showing a $50 loss due to the stock price drop. However, the drop didn't appear to help the put because it went from a $107 gain to a $10 gain. The small surge in implied volatility today wasn't enough to offset the time decay. Overall, implied volatility didn't ramp up like I had hoped, and I'll have to take a loss of $40. That's much better than losing the entire amount I paid to be in the trade.
Once again, I'm going to close this trade before the earnings announcement crushes the implied volatility, which could increase losses even more. So, I'll create, confirm, and send the closing order.
On-screen text: Long strangle trades. Rising implied volatility increases probability of success.
Narrator: I have two important takeaways. First, a regular long strangle tends to be a low probability trade because of the need for a large move. However, owning a strangle going into a potentially volatile event can increase the probability of success or the probability of a smaller-than-expected loss because of rising implied volatility.
On-screen text: Be mindful of costs in relationship to historical movements.
Narrator: Second, it's important to pay attention to the costs of trade and historical movements. Even if your focus is being long implied volatility, a big price move is the other avenue of success, so you don't want to set a roadblock by paying too high of a premium upfront.
As you may know, trading long options is very difficult because you must be right on the price movement, the time it takes to make the movement, and the direction of implied volatility. Trading long strangles ahead of an earnings announcement can make forecasting time and implied volatility a little easier.
Keep in mind that options trading involves unique risks and is not suitable for everyone and certain requirements must be met to trade options at Charles Schwab.
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