Friday, October 23, 2009

Saved By The Wings

So turns out the pessimistic view mentioned yesterday had the upper hand this go around with AMZN earnings. Indeed it was time for another trip to the woodshed for volatility sellers. It's like ISRG from last season all over again. This is the EXACT reaction condor traders use as the rationale for why buying the wings to limit risk is worth the extra commission/slippage and lower reward.

It's also the exact reaction that short strangle traders pray at night they never see. But the truth is you sell enough options gamma in front of earnings, you're bound to pay the piper sometime. Unfortunately the piper has a knack for showing up unannounced and unexpectedly.

So how would have buying wings been a saving grace with AMZN? And by "saving grace", I mean would have kept the loss somewhat survivable vs. the grenade going off in your face variety. Let's run some numbers:

Suppose you shorted an 80-105 Nov strangle yesterday bringing in $.90 for the put and $1.25 for the call. Given that AMZN opened around $112 this morning you would have found the put next to worthless ($.90 gain) and the call worth around $10 ($875 loss). So you're down about $800 PER CONTRACT. Bad enough had you even sold 1, let alone 3, 5 or 10.

How's about the 75-80 105-110 Iron Condor?

Well the put spread would have been worthless ($50 gain or so). The call spread was only down around $300, bringing the net loss to around $250. Which needless to say would have been a heck of a lot more manageable than the strangle.

Adam Warner of Daily Options Report brought up a great point in his post When Estimates Fail:

So goes the plight of any trader selling options gamma into earnings. Though they get to bask in the supposed "easiness" of profiting from the all but guaranteed volatility crush. Those pesky outliers are perpetually lurking in the shadows waiting to pounce a few times every earnings season.

For related posts, readers are encouraged to check out:

4 comments:

Justin said...

So it looks like I'll be picking shrapnel out of my face for a few days on this one. I sold a 75/115 SS Monday morning for $2.15, and was actually up almost 20% as of close yesterday, due to the IV dropping a couple days prior to earnings. I considered taking profits and closing yesterday, but NOOOOO, I had to get greedy and stay in. Bought it back this morning for $5.27. OUCH!

Tyler Craig said...

Yeah, these monster gaps are one of the necessary evils when it comes to playing earnings. I'd actually be glad that you only lost $3.00. Had you used different strikes or waited longer before you exited, it probably would have been a lot worse.

tjktrader said...

I backed off trading ISRG for real because of last months gap. But made $340 overnight on paper.
Made $320 real money last month on AMZN. It moved up day after earnings and then right back down. Good for the short straddle.
LESSON LEARNED - patterns for earnings responses are unpredictable.

I had to write when I read your blog. Your NOV 105/80 SS example is exactly what I did for real, 2 contracts.

WOW- Instead of hedging with options (condor) I hedge with stock. I hedged after hours yesterday by buying stock as it ascended. Had 90 shares of stock and felt somewhat protected.
Got up late today by accident,OOPS (Pacific TimeZone sucks for pre-market trading)

Well, it had gone from 107 to 114 and I was now behind the eight ball. I started hedging again throughout the day. Now with 170 shares long I'm almost delta neutral and can wait until things settle down.
Lesson learned - put on conditional orders no matter what.

POSSIBLE REPAIRS - Would like to buy back NOV 105 and sell DEC 130, but want some kind of indication of some slowing mom or resting from this insane upward movement. AMZN broke all time high!!
or - sell DEC 130/100 SS and manage from there.

Where do you think AMZN goes next week? Any thoughts on my ideas?

Tyler Craig said...

TJK- on the bright side at least you had some type of hedge on. Imagine the financial pain of the poor trader that didn't.

As far as where AMZN goes next week, you'll be ill served if you listen to my prognostication of where a stock should go. Flipping a coin will give you just as good odds as me calling the right direction...lol.

As for my thoughts on the management ideas.

1. Buying stock after hours: I've never done it myself, but I like the idea. Only problem is if the stock skyrockets before you can get in. So the speed and illiquidity of the market may bring up some issues. Since you've already been trading stock after hours your probably more familiar with dealing with this than I would be though.

2. As the short call moves deeper ITM, you probably want to just bail on the trade at some point. Remember, the extrinsic value will begin to diminish until the call is trading at parity (depending on how deep ITM it goes). I'm typically out of short strangles or condors if not when the short strike is breached, then shortly after.

3. As far as rolling forward to DEC. Ask yourself if you're doing it because it's a great trade of its own merits or if you're doing it in the hopes of making money back. My goal as a trader isn't to eke out a gain in every trade, but to minimize risk. So if based on your outlook on AMZN (volatility and stock price) you really like a DEC 100-130 short strangle at this point, then sure go for it. If you 're doing it to try to save the trade, well don't. Go find a better one.