How to Use Options Straddle for Expected Move
It’s going to be a slow week in terms of economic data releases. However, tomorrow, we’ll have the State of the Union Address. It has the potential to be a catalyst, pay attention to mentions of specific sectors like infrastructure and defense, which could send these stocks higher.
That said, my focus remains on macroeconomics, the volatility regime, catalysts, and crossover chart patterns (my money pattern). My weapon of choice remains options. It’s the fastest way I know that can multiply your money.
Now, stocks are relatively flat today and are as volatile as last night’s Super Bowl score. However, if you’re looking for catalysts today, look no further then Alphabet’s earnings, the parent company of Google.
And you know what?
According to the options market, it believes Alphabet could move by 5.1%, if you do the math, it’s about a $57 move (either up or down).
How do they come up with this figure?
It involves some basic arithmetic, involving puts and calls. Now, this stuff is important, even if you don’t trade options or earnings. We can use that information for potential entries and exits, as well as, profit targets and stop losses.
And yes, you can use it for FDA catalysts too…
As traders, we’re forward-looking and trying to figure out what a stock might do in the future. Well, since I primarily trade options… it’s pretty easy for me to do that, especially around earnings season, or around any big event for that matter.
What am I talking about here?
Well, when traders want to figure how much a stock or exchange-traded fund (ETF) will move after a catalyst event, such as corporate earnings, Federal Open Market Committee (FOMC) meeting, all they would need to do is understand how an options straddle works.
Before we get into how you can quickly estimate a stock’s or ETF’s implied move, let’s briefly go over the options straddle strategy.
Using Straddles to Estimate Expected Moves Around Catalysts
If you don’t know about the options straddle strategy, it’s simple. An options straddle consists of simultaneously purchasing one at-the-money (ATM) call option and one ATM put option. Keep in mind, the long call and put options have the same expiration date and strike price. Now, if you want a better understanding of the inner-workings of an options straddle… make sure to check out “Day 9 – Options Volatility Trading” and “Day 18 – Strategies with an Unknown Outlook” in my 30 Days to Options Trading eBook (it’s free).
That said, let’s take a look at the risk
Now, at-the-money just describes where the strike price is, in relation to the underlying stock’s or ETF’s price. For example, if a stock is trading at $99.50, an ATM option would either be the $99 strike price or $100 strike price calls or puts. Usually, ATM options are those with strike prices within 50 cents of where the stock is trading.
Here’s a look at the at-the-money straddle of the SPDR S&P 500 ETF (SPY) ahead of catalyst events.
Basically, the two lines that form the V shape is where your profit and losses lie depending on where the stock is trading. With the straddle, if the stock or ETF moves significantly higher, the call options would gain, while the put options would lose value. The opposite is true if the asset plummets.
Looks pretty simple right?
If you still want to learn more about this strategy, check out my 30 Days to Options Trading eBook.
That said, the long options straddle strategy, it gives us an idea of expected volatility.
You’re probably wondering, what does that all mean?
Well, if you don’t know… options are wasting assets and have expiration dates. So when options traders say something like, “The options straddle includes the earnings event” … it means the catalyst event falls on a day within the option’s life.
For example, the options straddle shown above expires on February 8, and the State of the Union Address is February 5. Additionally, there is a slew of other catalysts that occur before the option straddle’s expiration date.
But how does this help us to get an idea of how much a stock or ETF might move?
First, you would look at where the stock or ETF is trading. Then, you would find the strike price that’s closest to the underlying asset’s price.
Let me break it down for you…
Now, SPY was trading around $270, and if you wanted to get an idea of how much the market would move in the week of these catalysts… all you need to do is look at the at-the-money calls and puts expiring the Friday after those events. In other words, you would look at where the $270 strike price calls and puts expiring February 8 were trading.
The calls could’ve been purchased for $1.95, while the puts could’ve been purchased for $1.75.
That said, all you need to do is add those two prices together and divide it by where SPY was trading. Thereafter, you would get the implied move. So here, the straddle would cost a total of $3.70 ($1.95 + $1.75). For simplicity, let’s use $270 (SPY closed at $270.06 when I was looking at the straddle price) as the spot price (the spot price is simply where the underlying asset – for this example it’s SPY – is trading).
All you have to do is divide $3.70 by $270 and you would get the implied move, or expected move for that week. Pretty straight forward right?
That means SPY is expected to move approximately 1.37% that week.
Now, this could also be used for corporate earnings (this is a great tool to use during earnings seasons, which happens 4 times a year).
Using the Options Straddle for Earnings Events
Now, Ralph Lauren (RL) reports earnings February 5, so naturally, we look at the options expiring February 8. The stock closed at $115.78 on Friday (just a few days before its earnings release), so we’re looking at the $116 strike price calls and puts here.
Now, the calls could’ve been bought for $4.50, while the puts were worth $4.90.
That said, the at-the-money straddle was worth $9.40. Therefore, the implied move for RL during its earnings week was approximately 8.1%.
Sometimes, you could compare expected move to historical earnings moves
The implied earnings move is more, or less, in line with how RL has performed in the past. Here’s a look at the last 12 earnings moves (on a percentage basis).
Now, if you look at how much the stock closed post-earnings, it’s pretty dispersed. You have one earnings date where it fell 22.16%, and one where it was pretty much flat (closed down 0.66%).
What do we do with this data though?
We find the average of the post-earnings percentage changes. You can do this on pretty much any spreadsheet calculator. Don’t worry, we’re going to do all this for you at Weekly Money Multiplier.
So after finding the absolute value (making all of the percentage changes positive), we find the average move, which is approximately 7.63% – taking the average of the column titled “Absolute Close % (Post Earnings)”.
That said, the options are “fairly” priced.
Now, keep in mind, this is a rough estimate. Companies could move more or less than the implied move… so if you think you can just buy a straddle, thinking you might get paid… it’s a little more complicated than that.
If you do decide to buy a straddle ahead of an event, you need to be mindful that volatility would get crushed. You see, traders bid up volatility heading into a catalyst event. However, once the news is out, there’s nothing to really look forward to right? It’s almost like the old saying, “Buy the rumor, sell the news.”
Consequently, volatility gets crushed, and you will most likely end up losing money.
That said, the expected move could be helpful to manage your positions.
How to Use Implied Move for Stop Losses and Position Sizing
If you know the expected, or implied, move, it can help you with position sizing as well as stop losses. For example, let’s say you’re long options in Ralph Lauren (RL), and you know the expected move is around 8%. However, you’re only willing to risk around 3%.
If you’re in too many options contracts, you might want to consider reducing your size. Now, you could also consider a spread trade to reduce your risk.
Moreover, you could use this for stop losses. For example, let’s say you properly sized your position. If you bought options or stock when RL was trading at $116, you would just simply hit out of your position if RL falls below ~$112.50. Pretty simple right?
Not only that, you could use the expected move for entries. For example, if the stock moves significantly more than 8%, say over 20% in either direction, but the fundamentals don’t justify the move… you could use the “money pattern” to signal when it might be time to buy calls or puts.
Straddles Could be Applied to Events like Clinical Trial Data Releases…
Now, I’m no expert in biotech stocks… but Kyle Dennis is well-versed in that arena, in addition to options, catalyst events, fundamentals, and trends. He’s averaged more than $1M in trading profits per year, over the last four years using his profit buckets (various strategies for different market environments).
You could apply the exact same process to find the implied move for clinical trial data releases and. However, you generally would not have historical figures to compare the expected move to. This is due to the fact that biotech stocks don’t have scheduled data releases multiple times a year.
For example, Kyle Dennis sends out a watchlist to members, letting them know what he’s watching.
Here’s a look at his plan for one stock…
Amicus Therapeutics (FOLD) is expected to have a catalyst event on February 7.
Well, let’s look at the expected move for that week. Check out the at-the-money straddle on FOLD.
The stock was trading at $12.25, so we would just look at the $12 calls expiring February 8 (this includes the catalyst event).
That said, the straddle could’ve been purchased for $0.80. In other words, the market is expecting the stock to move around 6.5%.
Again, keep in mind, the stock could move much more than 6.5%, and sometimes it’ll move less than the expected move.
Look, we’re all looking for ways to improve our position sizing, and targets (for profits and losses). That said, implied moves can be used to improve those aspects of your trading.
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