A few years back, placing a ‘strangle’ or a ‘straddle’ on optionable stocks prior to their earnings report was “the way to go.”  In this article, I will point out that the times have changed and that placing a “sure thing strategy” is no longer such a sure thing.

For the purpose of instruction, I have presented two option strategies – Straddle and Strangle.

Prior to discussing the specifics of the strategies, I will briefly cover the basic differences and similarities of the two positions.  Figure 1 presents those facts visually.

Figure 1

For those readers who are unfamiliar with these strategies, I will explain Figure 1.  Basically, I utilized three criteria – option class, expiry month, as well as expiry strike price.  A straddle involves the simultaneous purchase of a call option and a put option in the same underlying market for the same month at the same strike price.  Both calls and puts are usually ATM (at the money).  By the way, those premiums are usually the most expensive ones.  A strangle, unlike a straddle, involves the selection of different strike prices for the calls and puts, while the expiration month remains the same as well as the underlying market.

Having explained the basics, I am going to move on to the specifics.  Prior to AAPL’s earnings release, I ran the following calculation for the straddle:
Straddle on AAPL @ 121.53
Remember that both the call and put in a straddle are ATM (at the money), but in reality, one will be slightly OTM (out of the money) and one slightly ITM (in the money) depending upon where the stock price is compared to the strike prices.

First Leg – Call Side
BTO + 1 May 120 call ATM @ 7.20 (- $720 goes out of our account)
121.53 – 120 call = 1.53 of intrinsic value. 
Therefore, out of the premium of 7.20, only 1.53 is pure intrinsic value.  The rest of it is not.  By itself, this indicates that the premiums are overpriced.  The extrinsic value of the May 120 call equals (7.20 – 1.53) 5.67.  By the way, the extrinsic value includes both time and volatility.  Implied volatility at the time of this exercise was high, and was reflected in the over-inflated option premiums for both calls and puts. 
Once again, 7.20 – 1.53 = 5.67 of non-intrinsic value.

Second Leg – Put Side
BTO + 1 May 120 put OTM @ 5.45 (- $545 goes out of our account)
On the call side of the straddle, there was some intrinsic value because the 120 call was at the money.  On the put side of the straddle, the 120 put was completely out of the money due to the fact that the price was at 121.53.  As a result, buying the 120 put on AAPL while the price was at 121.53 meant that the entire premium of 5.45 was extrinsic value.

This is an excerpt from May 2009 issue of Trader's Journal.