It’s that time of the year again: earnings season.

Earnings season is when companies report their numbers from the previous quarter. These figures can move stock prices sharply up or down.

For that reason, earnings season is the perfect time to use earnings strangles.

A strangle is an options strategy you might use when you are betting on a big move higher or lower for a stock. And earnings reports are some of the most common catalysts for these kinds of big moves.

Sounds easy enough, right? It’s not.

Let me lay it all out for you.

To pull off a winning earnings strangle, you have to…

• Pick the right strike prices for both the puts and the calls
• Pick the right company
• Pick the right expiration date.

But the beauty of an earnings strangle is you can make money regardless of which direction the stock goes.

The point of the trade is to buy a put option and a call option so you’re covered in the event of either an upside move or a downside move.

What you want is for the stock to move enough (in either direction) that the price of one of your options rises above the total price you paid for both.

Here’s an example.

Let’s say that AT&T (T) is trading at $14 and you are betting that the stock will move big after reporting earnings. In fact, you expect a move of at least 10% based on historical moves and the current setup.

In our example, the $14.50 calls are trading for $0.50 and the $13.50 puts are trading for $0.50. That’s a total cost of $1. This means that after earnings, the price of either your put or your call must rise to at least $1 for you to break even. Anything above $1 will be your profit.

So if AT&T moves 10% (or $1.40), you will usually make around $0.40 (or a 40% return) on your $1 investment. It’s a bit more complicated than that, but I’ll keep it simple for now.

The main point is this: The direction is meaningless. The size of the move is what counts.

If you look at the chart below, you’ll see AT&T’s recent performance. The company reported earnings last Thursday, October 19. Notice how the stock made a big jump right after earnings and has continued to move sharply up and down since. That’s because investors have digested the numbers and commentary from the company.

In this case, it may have been wiser to use a strangle that expired the week AFTER the earnings release to give yourself some cushion. But that likely would have reduced your returns, as extra time costs money.

The most important thing to pay attention to is the implied move for the shares after earnings. This is indicated by the price of the closest at-the-money option that has the soonest expiration date. (For more information on post-earnings surges, check out our Lead Technical Tactician Nate Bear’s article here.)

If the underlying option is predicting a huge move, then you likely will not make money, because the option will already be very expensive.

What you want to look for is a situation where the market is NOT expecting a huge move and has therefore underpriced the options. That’s where a surprise in earnings can lead to a sizable move.

YOUR ACTION PLAN

To figure out these earnings situations, you must research stocks’ historical moves after earnings. You also have to know the companies’ official expected earnings and unofficial “whisper numbers” (which represent what the market is really expecting). And lastly, you need to know the technical support and resistance levels.

Or, if you want to get all this data fed to you every trading day without doing any work yourself, you can check out my colleague Bryan Bottarelli’s trades in The War Room. Bryan specializes in overnight earnings strangles – last week he closed a 16% return on an earnings strangle on Discover Financial Services (NYSE: DFS) in less than 24 hours.

Go here to learn more about Bryan’s process for trading overnight strangles.

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