Straddles and strangles around earnings: implied move and volatility crush

What you will learn

• How to read the market's implied earnings move from the at-the-money straddle.
• What volatility crush is and how to estimate its effect on a position.
• Why a long option can lose even when the stock moves in your direction.
• How short premium positions around earnings make money and how they lose it.

Explanation

A straddle is a call and a put at the same strike and expiry, usually at the money. A strangle uses an out-of-the-money call and put, so it is cheaper and needs a bigger move. Bought, both profit from a large move either way; sold, both profit if the move is small. Their payoffs follow from the basic positions in the course Derivatives: Futures, Options, CFDs and Certificates.

The implied move

Before a scheduled report, the expiry containing it carries very high IV (lesson 2: backwardation). The at-the-money straddle price in that expiry is the market's estimate of the move. Rule of thumb: implied move is approximately the straddle price divided by the stock price; a more careful version uses about 85 percent of the straddle.

Volatility crush

Once the report is out, IV drops sharply, often by half or more within minutes of the open: the volatility crush. All options in that expiry lose much of their time value at once. A long straddle must see a move larger than the implied move to profit; for a short straddle the crush is the main source of profit, and the risk is a larger-than-implied move.

Right on direction, wrong on price

A trader who buys a call before earnings and sees the stock rise 3 percent often finds the call barely changed. The intrinsic gain was offset by the time value lost when IV collapsed: direction was right, but the price paid already contained a larger move.

Three honest observations

• The implied move is a price, not a forecast. Whether implied moves overstate realised moves for a given stock is something to check in historical data, for example with the tools of the course Python for Traders.
• Short straddles and strangles have unlimited (call side) or very large (put side) loss potential, and earnings gaps make stop-loss orders useless because the stock opens at the new price. Sell premium around earnings only with wings (iron condor or butterfly), or not at all.
• Bid-ask spreads widen before the report and after the open; the liquidity filters of lesson 1 matter more here, not less.

Worked example

Hypothetical example: a stock at $100 reports after the close today. Options expire in 3 days. Pre-report IV in that expiry is 80 percent. Model mid prices: 100 call 2.90, 100 put 2.90, so the straddle costs 5.80; 105 call 1.05, 95 put 1.05, so the strangle costs 2.10. Interest and dividends ignored.

Implied move: 5.80 / 100 = 5.8 percent (about $5.80); the 85 percent version gives about $4.90.

Next morning the report is out, IV drops to 35 percent, and there are 2 days to expiry. Model values after the crush:

For the +5 percent row: the call has 5.00 intrinsic value plus only 0.05 time value at 35 percent IV with 2 days left; the put is nearly worthless. Straddle 5.10 against 5.80 paid: a loss of 0.70 ($70) although the stock moved almost the implied amount. The long straddle needs roughly $5.80 either way to break even after the crush.

Long call buyer: paid 2.90 for the 100 call; at $103 it is worth 3.15, a gain of 0.25 that the bid-ask spread can erase. Right on direction, flat on money.

Short straddle seller: received 5.80. At $103 the position is worth 3.30: profit 2.50 ($250). At $110: loss 4.20 ($420); at $120: loss 14.20 ($1,420). This is why premium sellers cap earnings risk with wings.

Exclusions: commissions, the wider bid-ask spreads around earnings, taxes, early assignment.

Common mistake

Practice activity

On paper: a stock at $40 reports tonight. The 2-day at-the-money straddle costs 3.20. (a) Calculate the implied move in percent and dollars using the simple rule. (b) The next morning the stock is at $42.50 and the 40 call is worth 2.55 while the 40 put is worth 0.05. Compute the long straddle result and the short straddle result. (c) At what two stock prices would the long straddle roughly break even if time value is assumed to be zero after the crush?

Key takeaways

• The at-the-money straddle price in the earnings expiry is the market's implied move; write it down in dollars before trading.
• Volatility crush removes most time value after the report; long options need a move larger than the implied one to profit.
• Being right on direction is not enough when the option price already contained a larger move.
• Selling premium around earnings profits from the crush but faces gap risk that stops cannot protect against; use defined-risk structures or stay out.

Next step

The next lesson moves from events to a slow, repeated income process: the wheel, from cash-secured puts to covered calls, with a cost-basis ledger and an honest comparison with simply holding the stock.