Monday, September 28, 2009

Lessons Learned from a Trip to the Woodshed

So the RIMM trade didn't work out as we would have liked. Indeed, RIMM was taken behind the woodshed and beat severely (or at least more severely than expected) for its disappointing earnings. I don't even know what the actual earnings were, nor do I really care. The price reaction should tell us all we need to know. As far as volatility and the strangle play go, despite the vol ramp up into earnings and "apparent" overpricing, turns out the vol wasn't so "overpriced" after all. Rather than bemoan our fate as volatility sellers, let's take a look at what we can learn from our trip to the woodshed. Although today's musings may not assuage your financial pain (assuming you took a short vol play), at minimum it may shed (pun intended) insight on how to properly approach and manage volatility plays.

1. IV-HV analysis is NOT infallible. No matter how high implied volatility is compared to historical volatility, options can still be underpriced. Pre-earnings on RIMM, IV was at 56% while HV was at a mere 26%. The assumption we make when IV is extremely (you be the judge for what determines "extremely") higher than HV, is that options may be overpriced. There's certainly a better chance of them being overpriced when IV is higher than HV vs. being lower than HV in my opinion. However, past is not always prologue! Just because RIMM experienced 26% volatility over the last 30 days doesn't mean it can't experience 100% volatility in the next 30 days. Because options are forward looking and no one knows the future there is always uncertainty in making volatility bets.

Though we weren't making a directional bet with the RIMM strangle, we were making a volatility bet or magnitude of the expected move bet. Although I'll concede that forecasting volatility is usually easier than forecasting direction, it's still not infallible. Unless your deluding yourself, those of you that have been in the game long enough know there is no such thing as a sure thing when forecasting the future. If you haven't been in the game that long or are sitting on the pine thinking about entering the game, well then take my word for it.

2. Don't be stupid when position sizing. I think the plain old phrase don't be stupid PERIOD would have worked, but I wanted to focus on stupidity in the context of position sizing. No matter how confident you are in a trade, don't put in more money than you can afford to lose! I ended up entering the RIMM strangle at around $3.60 credit. I exited for a $5.20 debit resulting in a loss of about $1.60. Had I merely entered 1 lot of strangles, I would be down a mere $160. Had I entered a 10 lot, I would have lost $1600. A 20 lot would have lost about $3200. Remember, you are in almost complete control of risk by controlling the size of your position.

3. Have an exit plan. Check your HOPE at the door. When most traders (myself included) have a large gap against them in this type of trade they obviously hope the stock attempts to fill the gap. There's nothing necessarily wrong with that as long as it doesn't get in the way of your exit strategy. Although I hoped RIMM would rally higher through the day, I didn't want to lose more money by having the bottom fall out of the stock. So I used the first 5 minute candles low as my trigger to exit. If throughout the day RIMM is able to stay above that low and move sideways or higher, I'm holding on to make some money back. If it breaks the low, I'm out (click image to enlarge).

[Source: EduTrader]
Using the 5 min. low turned out to be a pretty good exit, as once it was broken RIMM continued its selloff.
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Bill Luby said...

Excellent post and just the sort of valuable lessons we all need to learn and internalize when things go wrong -- as they inevitably will about half the time.



Tyler Craig said...

Many thanks Bill-

Mark Wolfinger said...


It's necessary to point out that not all trades can be winners.

As strange as it seems, many people believe that a 90% probability of success means that you are going to win the 'bet' and have a profitable trade. The understanding that you will lose money one time is ten is lost.

Good trade, good risk management, and better luck next time.

Tyler Craig said...

Good Point Mark-

Perhaps some that read "HV-IV analysis is NOT infallible", and "there's no such thing as a sure thing when forecasting the future", don't understand that I'm essentially stating that not all trades can be winners.

Justin said...

Believe it or not, I'm still behind the woodshed. I closed the 105 call immediately after open on Friday, and held the 65 put hoping for a refill. Well, I'm still waiting. There looks to be a bit of support in the $66 to $66.10 area, if it breaks below 66 I'm going to take a realized beating and get out.

Tyler Craig said...

yeah, the minor tussle behind the woodshed at Friday's open has turned into an all out boot stompin for those naked puts. Last earnings seasons ISRG reaction bolstered my reserve to bail early if I was wrong.


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