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Option Basics - Anatomy of a Losing Trade

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As traders, we often focus on winning trades; not the losers. However, there is more to be gained by reviewing losing trades to understand what can be done better (or should be avoided) in the future.

When considering a trade, you should know the POP (the probability of profit), risk level SD (standard deviation), and any events that could affect the IV (implied volatility) and direction of the underlying.

Tasty Trade recently conducted a review of a potential trade in AAPL (Apple) to demonstrate that the POP, while correct at the time the trade is entered, is not a guarantee of success (POP will change each day). On 4/18/13, AAPL at $397.11 had an IV 45% and a POP of 68% for the May 13 415/420 Call credit spread; the premium collected was $1.63 for 29 DTE (days till expiration). This is a typical collection of one-third the width of the spread (about 0.5 SD) that Tasty Trade normally promotes.

Results of Monthly Call Credit Spread Trade (see Table above)
The trade was initiated because of the high IV of 45% and extreme IV Rank of 92%; high levels due to an earnings announcement scheduled for the 23rd after the Close. The expectation is that the collapse in IV will enable the trade to become profitable just after the announcement; else wait till a profit level of 25%-50% of premium is realized (through expiration, if necessary). The May 13 Monthly option with 29 DTE was selected by Tasty Trade reflecting their strategy of using chains close to 45 DTE.

Unfortunately the trade never reached 25% of the premium ($0.41 of $1.63), and ended with a loss of $337 (100 * (1.63 - 5.00)) as the price of AAPL reached $433.26 at expiration.

Upon review of this trade, we are concerned about the following: first, using one-third the width of the strike for premium usually results in the short strike being less than 1 SD OTM (out of the money); when holding for 29 days, it is easy to exceed the short strike if the underlying starts to trend. While we agree that IV will likely revert to the mean, this is not true for price (there is no tendency to reversion).

And second, when placing a trade in front of an earnings announcement, we should be taking advantage of high IV (and its subsequent contraction) without a directional bias. If we had placed our short strikes using 1 SD for an Iron Condor (450/460 Call spread; 345/335 Put spread, the premium would have been $2.37 (0.89 + 1.48). While the short strike of the Call was exceeded ($463.84 on 5/8), the price of AAPL did pull back by expiration and the trade would have realized full premium (or we could have exited much earlier with over 50% of the premium by the end of April).

Results of Weekly Iron Condor (see Table above)
At Options Annex it is our position that if you reduce the DTE (using a Weekly chain rather than a Monthly chain), you reduce risk while increasing the average daily premium (studies we've conducted with the SPX over 5-years supports this position).

Recognizing that an earnings event is imminent, using the 8 DTE APR4 13 option chain with an IV of 65% (20 points higher than the Monthly) offered more premium ($2.38; $1.34 Call credit spread plus $1.04 Put credit spread) at the same level of POP (68%; or 1 SD). We selected the Iron Condor since we do not have a directional bias for an earnings play, and the higher premium helps reduce risk (1 SD vs. 0.5 SD for the Monthly).

Despite the fact that AAPL started moving up after its earnings announcement, it never came close to the Call short strike of 430 (the highest level reached was 415.25). The total premium received was realized at expiration, April 26th.

In conclusion, recognizing that AAPL's high IV was primarily due to a pending earnings announcement, it is best to go at least 1 SD OTM (or more), and to employ a non-directional strategy (like the iron condor) to pull in more premium. The shorter DTE of the Weekly provided lower risk with greater average daily premium than the Monthly. In effect, the Weekly iron condor allowed collecting the same premium as the Monthly iron condor, but in only 8 days vs. 29 days for the Monthly; and it avoided touching the short strike of the Call spread.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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