...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.
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I tackle bad earnings trades with a  two-pronged approach:

1. Roll the untested side in  (bring the untested side closer to the tested side)
2. Roll the tested side out to next options cycle to give myself duration to be correct

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)

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:

• I try to stay delta neutral as far as I can.  Being delta neutral means that I don't have any directional bias even if stock goes up or down after an earnings announcement. I can never truly have a good sense or intuition about the direction of a stock, as I cannot predict how the stock will move after earnings.  The nature of the announcement has no bearing on direction. A good announcement can dip the stock price while bad news could send the stock soaring high.
• However, there are times when I do take a directional bet on the stock and go long or go short. My directional assumptions are not predicted by any technical or fundamental analysis, but rather dictated based on my portfolio's beta-weighted delta (to be further explained in future post). (As you might be noticing, delta is key) At a high level, my beta-weighted delta tells me the impact a one dollar move in the stock market would have on my portfolio.  So if, for example,  I currently have a huge negative beta weighted delta and if a highly correlated stock, like GOOG, AAPL, AMZN, were to be announcing their earnings, I might take a position in direction opposite to my portfolio. That is, I'll neutralize my negative deltas in portfolio by adding some positive deltas (or going long) in GOOG or AAPL, or AMZN.
• Watch the IV numbers across the different options cycle. The nearest options chain would have a really high IV compared to the subsequent option chains later in time. This difference between front and back option cycle can give you an idea of how inflated the IV is. The whole game is to sell inflated premium prior to announcement and buy it back after announcement once the IV collapses.
• I never buy premium going into earnings (as studies and research done by TastyTrade has shown that it's something that'll never work over a long haul). While there may be a few successes here and there, I don't consider it a sustainable strategy.
• In terms of money management, I try to stay small, with none of my positions exceeding 2% to 5% of the portfolio size. Given various accounts, strangles are naked/uncovered positions which have theoretically undefined risk and can't be placed in a retirement type account. The buying power reduction of one naked put is around 20% of the price of the stock. So, if NFLX is trading at $160, one short put would need a buying power of about 20% of $16,000 which would be about $3,200. Adding an extra short call wouldn't increase the required buying power as the risk is only one sided. So one can view the buying power reduction on a short strangle as around 20% of the stock price (might vary slightly given the volatility, market conditions, interest rates etc, but it's a good rough estimate to use) For these reasons, I try to stay small in my positions. 
• My favorite delta neutral strategy is to sell strangles at one standard deviation. That is, sell a 16 delta call and sell a 16 delta put in the option cycle nearest to the earnings.  While all the research on TastyTrade has shown that the 16 delta option provides the best bang for my buck, during earnings I like to go a little further away primarily for two reasons:
  • by going further away from 16 to 10 delta, the buying power reduction is a bit less
  • in my experience 16 delta positions would need a lot more active management, which is not easy during the school year :(
• The "MMM" market maker move on the TOS platform gives a quick and easy reference number that's a one standard deviation expected move (this can also be easily calculated! - see earlier post on this topic).  Given the "MMM" number, I like to add 25% or 50% buffer and sell strangles.

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! :) 
-Nisha

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-$1.40. To profit, the stock must be above the break even price)
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3. Combined Both transactions were sold at ATM (at-the-money, or equal to current market price) strike prices. The premiums sold were the midpoints of the respective option's bid-ask spread. In order to profit, with the combined transaction, the stock's price must be above below the #1's break even price and above #2's break even price. This means I must be within +$.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!