To the newcomer, the option market is often looked at as the frustration market. Perhaps nowhere else can you be so right, yet still lose money. Those unwilling to embrace the new dimensions inherent with option trading will be plagued by poorly structured trades vulnerable to attacks from unforeseen foes. Consider the following example:
I purchased the February 60 Puts on CRM. Following my purchase the stock rose a bit causing my puts to drop in value by about 30%, which made sense to me.
On November 17th the stock dropped hard. This brought me back to a slightly positive of about .08 profit per put. Earnings was released last Thursday night and the stock tanked hard – down $11. What perplexes me is that my puts lost value between Thursday and Friday. I was down .49 per put.
So on Thursday’s decline I come back into a profitable position and with Friday’s sharper decline I lose a good chunk of my value. What am I missing here?
What we have here is a trader who became the victim of two things: poor trade structure and volatility. With CRM sitting around $130 at trade inception, the 60 strike puts were not just out-of-the-money, they were completely off the map. It’s almost too generous to call them a lotto ticket. Though the original intent for snatching up far out-of-the-money puts is usually to keep cost to a minimum, it brings with it the huge disadvantage of being an extremely low probability bet. To say nothing of the fact that these puts may appear cheap in price terms, but are usually quite expensive in volatility terms. A better alternative for the frugal minded would be to buy fewer contracts of a higher strike, closer to the money put, or enter a simple put vertical spread.
The second culprit came in the form of volatility crush. Implied volatility has a well established pattern of rising pre-earnings while getting crushed post earnings. CRM was no exception as volatility plummeted in spectacular fashion on Friday (see chart below). The predictable volatility crush can be avoided, if not outright exploited with proper trade structure. A superior alternative to the outright put purchase would have been purchasing a vertical put spread with virtually any strike prices above $60. No doubt the outcome would have been much better.
Source: Livevol Pro
{ 7 comments… read them below or add one }
John,
I appreciate how unhappy our newbie option trade is with the results of the trade. But this is someone who is not ready to trade options. He needs a good lesson on strike price selection. He also has to understand that buying OTM options is a high risk strategy.
Appreciate the thoughts Mark. And I agree on all accounts.
By the way – who is John?
nice post – I might add a few words for your friend: implicit in the price (the implied vol, really) of the deep out of the money options was the possibility that CRM might implode on earnings – to the tune of 20%/30%/40%. That didn’t happen.
Also, it would be sweet if you could add a graph of CRM’s IV to this post to really drive the point home.
Thanks for the added insight Kid. Vol chart has been added.
Hi Tyler/Mark, you guys have any good resource suggestions for strike price selection? I.e. How do I know which strike would be the best to use for this situation?
Hi Nick,
I offered a few thoughts on strike selection in my new post: http://www.tylerstrading.com/simplifying-option-selection/
What strike price you use really depends on the strategy. In the post I provided a few ideas on strike selection for call and put option buyers.
Thanks, will look at it!
{ 3 trackbacks }