A popular trade around earnings involves a straddle, namely buying an at-the-money call and put with matching strikes. This strategy is long volatility, with the buyer profiting in situations where volatility is higher than anticipated as a result of earnings news.
Earnings speculation is a favorite pastime of many retail investors, since surprise news can illicit big stock price responses. However, picking the correct directional move is obviously a challenge. The benefit of the straddle is its delta neutrality, meaning that it isn’t overly sensitive to small stock price movements. Though the pure volatility risk of a straddle tends to make it a loser on average, investors will sometimes pay a premium for this volatility exposure, since it can occasionally produce outsized gains.
Short-dated straddles are also sensitive to highly gamma or “jump” risk. This strategy profits from sudden jumps in the underlying stock price. Since these options are so close to expiration (after earnings are announced), there’s much less relative time value embedded in their prices. The risks associated with gamma exposure command an even bigger premium, resulting in even larger average losses compared to long volatility.
An analysis on Micron Technology (MU) earnings (below) shows that short, dated straddles were highly profitable up until Q4 2019, after which these trades started experiencing significant losses. This is due to the realized underlying stock return post-earnings falling short of the market expectations (implied move). This points to an adjustment of the market makers being able to more accurately price post-earnings reactions.
Interestingly, the options market is also predicting a smaller-than-average implied move for MU ahead of its Q4 Earnings on Jan. 7, 2021. Currently the expectation sits at 9%, significantly lower than the 16% averaged across the last 2 years of earnings cycles. This is consistent with a large body of positive analyst consensus: for reference, sell-side analysts at UBS, Wedbush, and Mizuho have all substantially increased their price targets. When analysts are in strong positive agreement, it tends to reduce the uncertainty in the news, often causing market makers to shrink the size of options premiums.
The analysis below offers more details on past implied moves for MU and realized straddle returns.
Given the most recent performance of straddles for MU, some investors may consider it beneficial to be short volatility and gamma through selling a straddle. However, this trade carries unlimited risk due to the fact that it involves selling naked options, without shares or cash reserved in advance to fulfill obligations at expiration. A more risk-averse trader might potentially consider selling a strangle. This strategy consists of selling an out-of-the-money call and put. The strangle can be less profitable but can often provide a larger cushion due to the fact the options are out-of-the-money.