SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Lessons From Facebook Earnings Disaster


Last week Facebook (NASDAQ:FB) had the biggest one day drop of market cap in history for a single stock. It erased $120 billion in market value. Of course, the odds of a such a big move are pretty small, but the result can be devastating. We saw that with Facebook. As options traders, what can we learn from this event?

FB is one of the mostly watched stock in the US stock market. Many options traders try to play earnings using FB options. 

There are few alternatives. We will backtest them using CMLviz Trade Machine.

 

1. Buying Call Options

This strategy involved buying call options on the day of the earnings announcement and selling them the next day. Here are the results:

image.png

Tap Here to See the back-test

This doesn't look so good. How about a bearish trade?

2. Buying Put Options

This strategy involved buying put options on the day of the earnings announcement and selling them the next day. Here are the results:

image.png


Tap Here to See the back-test

Looks much better. However, this result was heavily impacted by the last earnings release. You remove the gains from the last cycle, the strategy would be a loser as well.

image.png

Tap Here to See the back-test

How about buying a straddle (both calls and puts)?

3. Buying a straddle

This strategy involved buying a straddle on the day of the earnings announcement and selling them the next day. Here are the results:

image.png

Tap Here to See the back-test

Once again, big chunk of the gains came from the last cycle when the stock tanked ~20%. Removing the last cycle causes the overall return to become negative:

image.png

Tap Here to See the back-test

How about selling the straddle?

4. Selling a straddle

This strategy involved selling a straddle on the day of the earnings announcement and selling them the next day. Here are the results:

image.png

Tap Here to See the back-test

Overall loss - but again, ALL of the total loss came from the last cycle. If we remove the last cycle, the overall result becomes positive:

image.png

Tap Here to See the back-test

We performed the back testing using the CMLviz Trade Machine which an option back-tester created by Capital Market Laboratories (CML). It is a very powerful tool that allows you to back test almost any possible setup.

Tap Here to See the Tools at Work 

Those backtests confirm what we already knew (more or less):

Buying straddles before earnings is on average a losing proposition. You will lose most of the time, but you might win big couple times when the stock makes a huge move.
 

image.png
Chart from optionslam.com.

Based on those statistics, many options "gurus" suggest selling options on high flying stocks like FB,AMZN, NFLX etc. They claim this is a "high probability strategy".

What they "forget" to mention (or maybe simply don't understand) is that high probability doesn't necessarily mean low risk.

Here is an excellent example used by our guest contributor Reel Ken:

We load a six-shooter gun with one deadly round and play Russian Roulette for $100 per trigger squeeze. The odds are 83% (5/6) that you win. Does that make it low-risk? What would low-risk look like? How about a 13-round Glock where your probability of success is over 90%. For certainly, if one defined risk as favorable odds, we would expect many takers, but I'll bet there wouldn't be any.
 

The reason is simple: One doesn't define risk by the probability of success. I often see this mistake when pundits promote investing strategies such as selling deep-out-of-the-money-puts (DOTM) on volatile stocks and lauding the low-risk-nature of the trade. "The stock would have to drop over x% (6%,7%, 10%) for you to lose". Well, Facebook reminded us of the real risk in such strategies.


Yes, risk isn't the chance of loss, it is the magnitude of potential loss. Too many simply confuse probability with risk.


This confusion is because investors don't understand there is a completely other operative metric. They can easily put their hands around the potential loss and even recognize when a probability is very high or very low (I hope).


But probability isn't risk. And, though maximum loss is risk, maximum loss is very, very rare. The maximum loss on the S&P is it going to ZERO, and though that's possible, it isn't helpful for us to evaluate investing loss.


Lets check how this strategy would work for FB in the last cycle, by selling 1 SD strangle on the day of earnings. With the stock trading around $217, you would be selling 232.5 calls and $202.5 puts, for $208 credit. This is how P/L chart would look like:

image.png

 

The trade would tolerate around 7% move in each direction, which would work well most of the cycles. Based on the options deltas, the trade had ~70% probability of success. Not bad.

As a side note, the trade would require around $2,850 margin, so even if you kept the whole credit, your return on margin would be around 7%.

Fast forward to the next day after earnings have been announced and the stock was down almost 20%:

image.png

The trade was down a whopping $2,407, which would erase 12 months of gains (even if ALL previous trades were winners).

Conclusions

  1. Earnings are completely unpredictable. In order to make money from earnings trades held through the announcement, too many things have to go right and too many things can go wrong.
  2. Selling options around earnings have an edge on average for most stocks, but they have a much higher risk than buying options, especially if the options are uncovered.
  3. Don't confuse high probability with low risk. You can win 70-80% of the time, but you can also lose few times in a row. And when you lose, you can lose big time.
  4. Those "one in a lifetime events" happen more often than you believe.
  5. Even if you did your homework and backtesting and decided to hold your trade through earnings, always assume a 100% loss and size your position accordingly.
  6. Even if the backtesting shows 90% winning ratio for a certain strategy, one huge move (in any direction) can erase months and months of gains.

The bottom line: trading options around earnings can be a very profitable strategy - but closing the positions before earnings will produce much more predictable and stable results with much less volatility.


"Trying to predict the future is like driving down a country road at night with no headlights on and looking out the back window." - Peter Drucker

 

Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • How To Start: Options Basics

    Today might just have the smallest gap between Wall Street and Main Street we’ve ever experience.  We’ve come a long way when it comes to common retail traders access, affordability of trade commissions, options trading education, research and analysis services, and, finally, some progress in accessibility of technology for options traders.

    By Drew Hilleshiem,

    • 0 comments
    • 93 views
  • Investors Are Not As Smart As The Media Thinks

    Over the last decade there has been a substantial rise in proclamations such as “investment advisors are useless,” “manage your own assets,” “don’t pay for financial advice,” and other similar sentiments. 

    By cwelsh,

    • 0 comments
    • 108 views
  • Should You Close Short Options On Expiration Friday?

    Options traders spend a lot of time trying to figure out the perfect moment to open a trade; but little attention is devoted to the other side of the transaction. When should you close? This applies equally to long and short positions. However, one aspect of short timing concerns expiration Friday.

    By Michael C. Thomsett,

    • 0 comments
    • 306 views
  • 8 Strategies For High Volatility Markets

    Trading in high-vol environments requires a different approach from low-vol markets. Here are 8 strategies to improve your trading and help you to survive in high volatility markets. They are very different from strategies in low volatility environment.

    By TFCAB,

    • 0 comments
    • 155 views
  • Selling Options Premium: Myths Vs. Reality

    Selling Options Premium refers to certain set of strategies that involve net selling of options, as opposed to buying premium where you are net buyer of options. There are a lot of myths and misconceptions about Selling Options Premium. This article will explain the basic concepts and debunk some of the myths.

    By Kim,

    • 0 comments
    • 643 views
  • Combining Momentum and Put Selling (Updated)

    In February of 2017, I wrote an article about combining together the concepts of momentum and put selling. You can find that article here as prerequisite reading. With this post, we'll look at how the strategy presented has done since then, along with some additional implementation ideas.

    By Jesse,

    • 2 comments
    • 473 views
  • Options and Invisible Risks

    Entry and exit timing is crucial to successful options trading, without doubt. However, one form of risk not often acknowledged is the risk of taking too many actions, too soon, and for the wrong reasons.

    By Michael C. Thomsett,

    • 0 comments
    • 499 views
  • The Volatility Option Trade In Alibaba

    This is why you have a Trade Machine membership. We can ride the evergreen patterns, and we have, for years. But when the market shifts, we need a minimum amount of data to adjust, and succeed -- now we will. This is our time.

    By Ophir Gottlieb,

    • 0 comments
    • 732 views
  • James Cordier: Another Options Selling Firm Goes Bust

    On November 1, 2018, a money manager named James Cordier from OptionSellers.com published an article on Seeking Alpha named Option Selling Opportunities So Good They're Scary. To me, this title alone would be enough to completely discredit the author and not trust him with my hard earned money.

    By Kim,

    • 10 comments
    • 4,956 views
  • Do You Have a Written Investment Plan?

    Meb Faber recently polled his twitter followers, and found that only about 25% have a written investment plan. Your investment plan should be based on your willingness (risk tolerance) and need (required rate of return to meet your long term goals) to take risk. 

    By Jesse,

    • 0 comments
    • 537 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs