Sunday, July 26, 2009

Wildest Dream or Worst Nightmare

The reaction to ISRG earnings certainly could have been your worst nightmare or perhaps your wildest dream. Indeed the huge gap up is precisely what volatility buyers (e.g. long straddle) covet and volatility sellers (e.g. short strangles) shun like the plague. So, if you're just getting into trading straddles/strangles and want a prime example on what can go right/wrong with earnings, well take a snapshot of ISRG and stick it on the fridge because there's a lot to be learned here.

After earnings, ISRG gapped 17% right off the bat and then proceeded to run like a scalded dog. By friday's close, a mere 2 days after the announcement, ISRG was up an incredible 31%. To say the move was unexpected would certainly be an understatement! Pre-earnings the Aug 210-140 strangle was trading around $3.00. After the insane 2 day rally, the strangle was around $18+. Supposing we thought options were overpriced and sold the strangle, we would have been down $15 per spread after 2 days (assuming no adjustments). That's 5x the potential reward... ouch!! (click to enlarge)

[Source: Edutrader]

Besides using the actual before-after prices of the strangle, another method for analyzing the poor job the options market did in anticipating (and properly pricing in) this earnings gap is by taking a before/after look at volatility. The ISRG implied volatility charts show that pre-earnings, options were certainly pricing in an uptick in realized volatility (IV = 60%, 30 day HV = 40%), but certainly not enough as current-post earnings 30 day HV sits around 80%. In other words, the options board accurately predicted that the underlying was about to realize more volatility than it had in the recent past. However, they failed to price in the magnitude of just how much more volatile ISRG would actually be.

[Source: IVolatility]

The reaction to ISRG announcement is the exact scenario that cynics use as ammo in arguing against selling strangles. After all, one loss such as ISRG could wipe out ten trades worth of gains. Which highlights an important point>> Successful option trading isn't so much your win-loss record as it is your trade management.

In other words, I could have a trading system where I short strangles into every single earnings announcement. Although my winning percentage may be around 85% it doesn't mean I'm going to be a slam dunk winner. Suppose I make $200 on the average winning trade but lose $1200 on the average losing trade. Well, my expected return is still negative ($200 * .85) - ($1200 * .15) = -$10, thus in the long run I'd be a net loser.

From ISRG I think we can learn two important lessons. First, proper trade and money management are integral to becoming successful trader- regardless of the strategy. Second, becoming a successful option trader requires flexibility in one's approach. During certain market environments you may want to be a net buyer of options (or volatility), while in others you'll want to be a net seller of options (or volatility). Neither one works all the time!

Next time we'll delve further into these two lessons...

6 comments:

Mark Wolfinger said...

"From ISRG I think we can learn two important lessons. First, proper trade and money management are integral to becoming successful trader- regardless of the strategy. Second, becoming a successful option trader requires flexibility in one's approach."

Please tell me that you already knew this and this incident was merely a reminder.

I would go further than you. To me, risk and money management is the 'whole ball game.' Many strategies can work when well managed, but the best strategies are doomed when risk is ignored.

Tyler Craig said...

Mark,

Thanks for the comments-
Certainly the two lessons were a reminder. I don't presume to think that I'm introducing any new ground breaking trading concepts here, rather I merely wanted to shed more insight on them in the context of long or short volatility plays. I would also hope that the majority of readers already have a strong belief as to the importance of trade/money management. ISRG served as a prime candidate as to why risk management is harped on so much, thus I offered it up as food for thought:)

Mark Wolfinger said...

It's not that it's 'new ground' - but it is a very important reminder.

I would hope the same as you, but my experience tells me that most traders don't recognize just how much money can be lost - until it is lost.

Perhaps it's one of those lessons we have to learn for ourselves.

Tyler Craig said...

I agree. Sometimes the school of hard knocks has to be attended personally before one will learn.

3percenter said...

I paper traded the Aug 135/210 short strangle for a $1.1/$1.15 credit, respectively. Bought back the put for a nickel, still sitting on the call, currently at $14.70. We'll see what happens. Thank God for the small favor of "You don't have enough buying power to complete this transaction".

Tyler Craig said...

3percenter,

lol.. yeah apparently not having any money available can be a good thing every once in awhile.