...and, now, the not so good earnings trades.
In my last post I discussed all my 'good trades' that worked perfectly. Unfortunately, this is not always the case. There are times when you might sell premium 1 or 1.5 standard deviations away and the stock price moves more than your expected comfort level, resulting in a loss post-earnings.
Despite this setback, I rarely close my position for a stop loss on earnings trades. Learning the defense mechanism to handle the loss (lower the loss or scratch the trade) or even turn the loser into a winner is an extremely valuable skill to have as a trader, and allows you keep your portfolio in the green.
I tackle bad earnings trades with a two-pronged approach:
Let's look at my earnings trade with Netflix which went against me at first, but turned around as I patiently worked through it:
The earnings were supposed to be announced after market close on Mon, July 17th. The MMM (market maker expected move) was around $11 for the options expiring that Friday (4 days away). With stock trading around $161, I opened a short strangle about 2 hours prior to close. The strikes I chose were 138 for puts and 185 for calls (this was more than twice the MMM expected move range). I sold 5 strangles (5 each of calls and puts). NFLX is a kind of stock that is typically range bound when there is no earnings, but during during earnings, it has a tendency to move 2 to 3 standard deviations. Though I was going out far on either side, there was still enough premium in there for my comfort level.
After the earnings announcement, NFLX opened around $176.12. Though it did not breach, the loss was significant. The first defense mechanism I used was to roll the short call (tested side) out in time to the following Friday while collecting additional credit.
Typically, I'd roll the put (untested side) closer to the call but given NFLX's propensity to move fast around earnings, and even post earnings, I left the put side as it was.
On Friday, July 21st, NFLX opened at 182.72; the puts were expiring worthless, so I sold the puts for the following week (but a lot more closer to the price action). I skewed it a bit by selling only 2 puts against the 5 short calls as I expected retracement of the gap created during earnings.
When the stock pulled back a little on July 27th, I sold some more puts (I was still skewed with more calls than puts). The stock had opened at 189.89 and went on to close at 182.68
Finally on another big move down on July 31st, I sold two more puts. The stock had opened at 184.26 and closed at 181.66
Within the next two days, I had completely scratched the trade and went on to make a profit, equivalent to the profit I had initially expected on my original trade.
Here is a log of the trades I placed for this position and an equity curve showing my P/L. As you can see from the P/L chart and equity curve, through rolling I was able to extend duration and turn around a bad trade. (Click image to enlarge)
Earnings trades come in two flavors: good and bad. But this doesn't mean our outcome needs to be a loss. By proactively repairing our bad trades, we can hope to either minimize the loss, scratch the trade, or make a profit!
I repeated by favorite Netflix earnings trade, this earnings cycle in October. This time the price stayed range-bound, making it a good trade.
The third quarter earnings cycle just concluded couple weeks ago. In this two part post, I'd like to reflect on some of my earnings trades - the good ones :-)
An earnings cycle which typically occurs four times a year, for four quarters, presents a good opportunity for premium sellers to get engaged and gain some money from the increased IV.
We are living in a low volatility environment (with VIX hovering at a range of 10 to 12 for a good part of the year). Unfortunately, in a low volatility environment the opportunities for us premium sellers to be successful is extremely low.
Here is my go-to recipe for earnings trades:
Here are a couple of trades from this earning cycle. Please click on the image to see details of the trade:
I've posted 5 successful earnings trades above. Or as Tom (at TastyTrade) would call it "winner, winner, chicken dinner".
That was easy, right...? Well, not so fast.
Things worked out well on these trades, but there are trades that don't always go the way you'd like them to. That's why the topic of this blog post is 'Good Trades'!
In the next post, I'll highlight some 'Bad Trades' and show how I try to repair trades gone astray.
Thank you for reading! :)
Stock: UAL- United Airlines (Market Price: $53.50)
Volatility @ Sell: 49.83%
Volatility @ Buy: 42.00%
Volatility Contraction or "Crush": 7.83%
Expected Move: Midpoint of Bid-Ask Spread of Selling ATM Call: $.93 Midpoint of Bid-Ask Spread of Selling ATM Put: $1.40 Sum: $.93+$1.40= $2.33= Expected Move of stock's price
1. Sold call @ ATM Strike of $53.50 for premium of $.93 (To break even, the stock must not cross $53.50 + $.93. To profit, the stock must be below the break even price)
2. Sold put @ ATM Strike of $53.50 for premium of $1.40 (To break even, the stock must not go below $53.50-$1.40. To profit, the stock must be above the break even price)
3. Combined Both transactions were sold at ATM (at-the-money, or equal to current market price) strike prices. The premiums sold were the midpoints of the respective option's bid-ask spread. In order to profit, with the combined transaction, the stock's price must be above below the #1's break even price and above #2's break even price. This means I must be within +$.93 or -$1.40 of the ATM strike/current price. The total range of movement allotted for me to profit is $2.33.
As stated above, and not coincidentally, the expected move of a stock is determined by the sum of the midpoints between the bid-ask spread (mid-price fills) for selling ATM calls and put, or $2.33. The sum of the premiums (the midpoints) is the expected move and the range that I want to be in in order to profit!
Every quarter, most publicly traded companies release earnings reports to inform shareholders of their sales, profits, outlook for next quarter etc. Upon and preceding the release of these reports, fear strikes in the market. When fear is high, a stock's price is considered volatile and there is inflated implied volatility (IV) in the derivatives/options market. Increased implied volatility corresponds to increased option prices, allowing traders, who are typically premium sellers, to open short positions. Post earnings announcement the implied volatility collapses and the options price kind of 'normalizes'.
To get a sense of this heightened IV prior to earnings, you can look at the options chain. The options chain closest to the earnings date (front month/week) will display an very high IV when compared to the other options chains going out farther in time (back month/week). Say if the front week is displaying an IV of 25% and the back week is displaying an IV of 20%, we can infer that post earnings announcement, the IV of the front week will collapse by about 5%. This 5% volatility crush to is the volatility contraction that the premium sellers are counting on to profit off of. The greater the volatility contraction, or "crush", percentage, the greater traders with short position profit.
Eighteen-year old trader, future connoisseur of options.
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