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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results.

The strategy here is to buy the straddle two to three weeks ahead of earnings. Significant price movement is necessary for a straddle to make money and in the case of the earnings play, there are three events that can occur during this period which can create price movements sufficient enough to generate a profit.

Prior to the earnings, excitement abound and the underlying stock price may trade up or down ahead of the actual earnings due to increased speculation. Sometimes, price may move so much that you may be able to exit the position with a small profit without holding into earnings.

Immediately after the earnings annoucement, stock price typically gap up or down 5% to 10%, depending on the report. Movements of 10% to 20% are seldom but not uncommon. Rare is the case when stock price remains unchanged.

A third event, unlikely but not impossible, is the profit warning that may be issued a few weeks prior to the earnings report. Large downward movements are typical following such warnings and are usually big enough to allow for a profitable exit.

Unless you are very certain that the gap up or down after the report will be huge, never buy the straddle just one day before earnings as this is the time when the premiums of at-the-money options get bid up very high due to heightened anticipation. Do your homework and scout for companies announcing earnings two to three weeks in advance. Lookout for stocks displaying a history of gap movements during earnings by examining the historical price chart.

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