Every trader has their classic tough-luck stories – trades in which they got hammered because of something they didn’t know then, but surely know now. Earnings season is often a factor in these stories. I ran into such a tale recently from TK client metaprog. The following is an excerpt from metaprog’s forum post; it happened awhile ago (April 2009) but the trade is still worth exploring:
“I made a HUGE error recently. Decided to go long a strangle prior to earnings release. I thought the stock would jump 4-5% and chose a one-step farther out-of-the-money call than I did the put. The stock moved but not as much as I had hoped. Nonetheless I made a tiny profit of $60 on an $1100 position in a couple of hours. I placed a market order to close at market-opening the next morning. I woke up to find my account with a $700 LOSS. The bet I had made was correct, but getting out of the position killed me.
I failed to account for 2 HUGE factors... theta-decay and the volatility driving the options prices almost disappeared once news was announced. There was nothing else in the news or market pipeline to create time value for the options. I went from a 5% profit to a 60% loss in the blink of an eye.
So for the options experts out there - what could I have done differently? Should I have used May or June contract instead of Apr? Should I have bought in-the-money instead to dampen price decay? Should I have bought a straddle instead of a strangle? Was it a big drop in liquidity/volume that dropped the price? Also traditionally the more liquid a stock/option, the tighter the bid-ask spread. But I see this violated often. Why? Advice/insight would be greatly appreciated. Academically I’m quite versed in options theory and pricing but this is my first foray into trading my own real money and I’m trying to put market behavior into my muscle memory fast!”
Meta,
I’m sorry that your first option trade had such poor results. I know it’s small solace, but you fell into a trap that has caught many an options rookie. This trap is permanent, will never go away, but you can learn to avoid it.
Before we dive in, let me explain what a strangle is. (You can login to your TradeKing account and check out the full skinny under Education > The Options Playbook > Play #11 Long Strangle.) A strangle consists of the following:
• Buy a put, Strike Price A
• Buy a call, Strike Price B
• Generally, the stock price will be between Strikes A and B
Commissions at TradeKing is $11.20 to enter a 1-contract strangle.
The goal is to profit if the stock makes a big move in either direction. However, strangles are tougher to pull off than they seem. Buying both a call and a put increases the cost of your position, especially for a volatile stock. So you'll need a significant price swing just to break even.
Your max potential loss is limited to the net debit you paid, while your max potential gain is Potential profit is theoretically unlimited if the stock goes up. If the stock goes down, potential profit may be substantial, but limited to Strike A minus the net debit paid.
Now that we’ve established what a strangle is, let’s dive into some observations.
Prior to earnings, many investors want to own options – just in case there is a big move in the underlying stock price. And that big move occurs just often enough to continue luring traders to buy those puts and/or calls.
That increased interest in owning options around earnings season tends to drive option prices higher. One reason that occurs is because too many inexperienced buyers enter orders to buy those options, not caring what price they pay. That make the assumption that if the option is trading at $X per contract, then $X must be a reasonable price to pay. That is a false assumption. With earnings soon to be announced, option prices are usually high.
Thus, your first mistake was making this trade. If you understood this was a gamble, then you certainly had the right to give it a try. But because the options are almost always trading at an inflated price in this scenario, the odds of winning are small.
You described yourself as bullish, yet you bought a call option that was further OTM than the put. That was your second mistake. The right way to make a bullish bet is to buy a more attractive call option, and that means one with a lower strike price. Instead of buying the call one extra strike OTM, you should have done that with the put.
In other words, you spoke of making the correct bet, but actually you didn’t. You bought over-priced options and made a bet that was more bearish than bullish – despite the fact that you were bullish.
Entering a market order was your third mistake. Unless you are desperate to enter or exit a trade, never use market orders when trading options. That mistake was compounded by the fact that you entered a market order at the opening. That mistake (#4) is, sadly, a request to get ripped-off on the price of the trade.
You did the right thing by buying the less expensive April options. (Keep in mind this trade happened back in April 2009.) In this instance, you would have lost a smaller percentage of your money with May or Jun options, but the dollar amount would probably have been just as high. Those longer-term options are rich in vega, the Greek that measures how much options are impacted by implied volatility swings. (Learn more about vega from the Options Guy.) Once earnings are released, IV usually gets crushed – hurting those vega-rich options big time.
Your concern should not be to dampen time decay. When you bought those options, you knew you were going to hold for just one day – so time decay was not a issue. But owning in-the-money options is usually a better play, especially if IV is likely to decrease. If the stock moves your way, sometimes you can stand the IV drop and still show a profit, but that’s not true with out-of-the-money options (unless the price change is large).
Whether you chose a strangle or straddle is not important here. You should have bought a lower strike call. But the difference between the straddle and strangle is not the reason for the large loss. (You can review the details of a straddle at Education > The Options Playbook > Play #9 Long Straddle. Straddles are constructed like strangles and have the same max potential risk, profile and commissions to enter. The key difference is that straddles involve buying a put and call at the same strike price, versus separating the strikes as you do with a strangle.
It wasn’t a drop in liquidity that dropped the price – it was simple market demand. The previous day, prior to the news, many people wanted to buy options and bid up the prices. After the news, all those people wanted to sell their options, and drove the price lower.
That’s the problem when trying to make money from an earnings announcement – there are far too many traders doing the same thing. That’s why some traders take the other side of your bet. They sell options (usually spreads, not strangles) into the news, hoping the volatility crush will offset any losses due to market movement. I’m NOT suggesting you do that because it’s a risky play and for more experienced traders. But I do want you to realize that professionals tend not to do what you did – and that is buy options into pending news.
Sometimes market makers widen the bid-ask spreads when a “fast market” is declared. That means there’s a larger-than-normal influx of orders. With electronic trading there is no need for wider bid/ask spreads, but it is more profitable for the market makers and they do widen markets when allowed to do so. Just another reason never to use market orders.
I approve of being well-versed in option theory. But as this trade already showed you, theory isn’t the same as experience. The real world often differs substantially from what one would expect to see.
Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.
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