Playing a Strangle on WFR

OK, I currently lack some discipline (I have too much cash on the sideline), but I wanted to test a trading strategy last night. I knew that WFR was going to report last night and I wanted to get in the action. This is a stock I follow and I believed that would report good earnings, but the stock got crushed this week so I was not willing to bet much.

So how do you play WFR without betting wrong? I hedged. I set up a strangle with out-of-the-money options to play that the stock would move significantly, but the direction was unknown.

Now, I didn't want to bet real money here while testing a strangle strategy that I don't employ often, but virtual trading is not the same as having a little skin in the game. In this case, the money I risked is so small that I will use real values. I bought 5 WFR NOV55 puts at $1.95 for a total cost of $975. The stock was trading about $59.20 when I bought these options. I also bought 8 WFR NOV 65 calls at $1.65 (2 trades) for a total cost of $1320. I bought more calls than puts because I went with my gut that WFR would beat estimates. This gave me a ratio of 1.35 to1.

This morning, soon after WFR opened, the stock was trading for $67.30 and I was able to sell my calls for $4.00 or $3200 while my puts could only be sold for $0.10 or $50. This netted me a profit of $955 on a total risk of $2295 or a 41% profit. I also did not sell my puts in case the stock falls back over the next 22 days (for $50, it was not worth selling).

Betting only with the calls would have made me more money, but the hedge let me sleep. Either way, the trade would have worked out as profitable as long as the move was significant. When earnings happen the implied volatility decreases dramatically, meaning that your options lose value. It would have been a bad trade if the stock price was flat.

Sometimes, the best trade is hedged.