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This strategy involves buying Deep In The Money" (DITM) options to limit downside risk while retaining the full benefits of the stock. The options are purchased at a lower cost than the actual stock but still receive close to a $1 increase for every favorable $1 move in the underlying security which increases the percentage return for the same dollar move.
Advantages of stock replacement strategy:
Keeps all benefits associated with trading the stock. Reduces costs associated with owning the stock. Offers more leverage by increasing the potential percentage return. Offers lower downside risk. Disadvantages of a stock replacement strategy:
Needs good trading experience and skills to master the strategy. The strategy may fail, when the stock stays on (almost) the same price or moves sidewise. Leverage works both way - If the stock falls, the percentage loss is larger as well.
Let's check how you could use this strategy to reduce your cost of owning Apple. The stock closed at $174 yesterday.
Experienced options traders are usually well aware of this strategy and make good use of it.
Strategy No. 1: Buy 100 shares of the stock
Buying 100 shares will cost you $17,400. Not cheap. If the stock rallies to $185, you have made $1,100 or 6%. Let's see how it compares with the stock replacement strategy.
Strategy No. 2: Buy DITM call
As an alternative to buying the stock, we can buy the AAPL July 20 2018 130 call at $45.47. The cost will be $4,547 which is about 26% of the cost of the 100 shares. The P/L graph looks like this:
If the stock rallies to $185, you have made $1,030. This is slightly less than buying the stock, but percentage wise, it is a 23% gain, compared to the 6% gain when owning the stock. Of course the opposite is true as well - if the stock goes down, your percentage loss is much higher.
This is called leverage. It works both ways - you increase the reward if the stock rises and increase the risk if the stock falls.
However, if the stock falls, the volatility should increase which actually helps our option price because increased volatility can cause option prices to increase or not fall as fast. So basically even though we will gain $1 for every $1 the stock increases we will lose slightly less than $1 for every $1 the stock drops.
You might noticed that we gained only 93 cents for every $1 movement in the stock. This is due to the fact that the delta of the 130 call is 0.93. We could choose a call which is deeper in the money - it would have a higher delta and have a better replication of the stock movement. However, it would also be more expensive and provide less leverage. 0.90-0.95 delta provides a good compromise between 1:1 movement and a reasonable price.
Now let's see if we can do better.
Strategy No. 3: Buy DITM call and sell OTM call against it every month
Here is how it works:
Buy AAPL July 20 2018 130 call at $45.47 Sell AAPL Feb 16 2018 185 call at $1.55 We reduce the cost of our trade by $155 to $4,392, but we also limited our gains. The P/L graph looks like this:
As we can see, we increased the maximum gain to $1,147. This gain is not only larger than the dollar gain from owning the 100 shares of the stock, but also translates to a cool 26% in one month. If the stock is below $185 by February expiration, we can repeat the process with the March options. If it is higher, you just close the trade for a gain and can roll to higher strikes.
Of course if you believe that AAPL will be higher than $185 by Feb expiration, you will be better by just buying the DITM calls.
Strategy No. 4: Buy DITM call, sell OTM call and buy OTM put
Here is how it works:
Buy AAPL July 20 2018 130 call at $45.47 Sell AAPL Feb 16 2018 185 call at $1.55 Buy AAPL Feb 16 2018 165 put at $2.07 Our cost now is $4,599, still significantly lower than owning the stock. The P/L graph looks like this:
Our gain is now limited to "only" $900 (20%), BUT we also limited our loss to ~13% in case AAPL goes down after earnings. And if the stock really crashes, the position can actually produce some gains because at some point the long put will more than offset the losses from the long call.
This is a variation of collar, where we replace the long shares with DITM call.
And this is the beauty of options. You have almost endless possibilities to structure your trade, based on your outlook and risk tolerance.
Before investing any money, please make sure you understand what you are doing. Good luck.
By Ophir Gottlieb
That's great, because it means there is discord, and discord, especially for Apple ahead of earnings has meant a repeating pattern for the clever trader to take advantage of.
One week before Apple's earnings would be January 25th, 2018.
Sometimes a bullish momentum bet works great -- and in fact, for Apple that has been a strong pattern ahead of earnings. But with a toppy market, sometimes a different approach can work as well.
It turns out, over the long-run, for stocks with certain tendencies like Apple Inc, there is a clever way to trade market anxiety or market optimism before earnings announcements with options.
This approach has returned 189% with 10 wins and 2 losses over the last 3-years.
The Trade Before Earnings
What a trader wants to do is to see the results of buying a slightly out of the money strangle one-week before earnings, and then sell that strangle just before earnings.
Here is the setup:
We are testing opening the position 7 calendar days before earnings and then closing the position 1 day before earnings. This is not making any earnings bet. This is not making any stock direction bet.
Once we apply that simple rule to our back-test, we run it on a 40-delta strangle, which is a fancy of saying, buying both the 40-delta call and 40-delta put, for a non-directional bet on volatility.
If we did this long strangle in Apple Inc (NASDAQ:AAPL) over the last three-years, but only held it before earnings, using the options closest to 14 days from expiration, we get these results:
Long 40 Delta Strangle % Wins: 83.3% Wins: 10 Losses: 2 % Return: 189%
Tap Here to See the Back-test
The mechanics of the TradeMachine™ are that it uses end of day prices for every back-test entry and exit (every trigger).
We see a 189% return, testing this over the last 12 earnings dates in Apple Inc.
We can also see that this strategy hasn't been a winner all the time, rather it has won 10 times and lost 2 times, for a 83.3% win-rate on an one-week trade.
While this strategy has an overall return of 189%, the trade details keep us in bounds with expectations:
➡ The average percent return per trade was 16.9% over 7-days.
➡ The average percent return per winning trade was 21.8% over 7-days.
➡ The average percent return per losing trade was -7.6% over 7-days.
We like the comfort of a trade that, when it loses, it isn't a disaster -- at least not historically.
Option Trading in the Last Year
We can also look at the last year of earnings releases and examine the results:
Long 40 Delta Strangle % Wins: 100% Wins: 4 Losses: 0 % Return: 98.2%
Tap Here to See the Back-test
In the latest year this pre-earnings option trade has 4 wins and lost 0 times and returned 98.2%.
➡ Over just the last year, the average percent return per trade was 22.3% over 7-days.
We don't always have to look at bullish back-tests in a bull market -- sometimes a straight down the middle volatility pattern pops up. This is it -- this is how people profit from the option market -- finding trading opportunities that avoid earnings risk and work equally well during a bull or bear market.
To see how to do this for any stock we welcome you to watch this quick demonstration video:
Tap Here to See the Tools at Work
You should read the Characteristics and Risks of Standardized Options.
Past performance is not an indication of future results.
By Ophir Gottlieb
Here it is -- a portfolio of FAANG stocks using pre-earnings trading. A 3:30 video that is staggering and includes some robustness testing.
Reminder that you can sign up for Trade Machine as a Steady Options member here:
Given the power of stock options to leverage your investment dollars, you might be tempted to bet on the earnings report coming out today by buying Apple calls (if you think the stock is going up) or Apple puts (if you want to bet that it will go down).
That bet paid off handsomely in July 2016 when Apple reported earnings. The stock rose 6.5% the next day and the value of Apple’s weekly calls increased dramatically.
But that’s the exception, not the rule.
As I showed in one of my Seeking Alpha articles, buying either puts or calls just before Apple’s earnings report is, on average, a losing proposition.
When you look at longer timeframe, AAPL tends to move less than expected. Take a look at the screenshot from optionslam.com, showing the post earnings movement of the stock in the last 10 cycles:
The explanation for those numbers is simple. Over time, the options tend to overprice the potential post-earnings move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
The last column shows the one day post earnings performance of the weekly straddle. As we can see, it has lost money 8 out of 10 times. Which means that 8 out of 10 times the stock moved less than expected. If I had to choose, I would take the other side of the trade (selling those options).
Jeff Augen, a successful options trader and author of six books, agrees:
"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
Is Your Risk Worth The Reward? Why We Sell Our Straddles Before Earnings Risk Reward Or Probability Of Success? Whatever You Do, Don't Do This Before Apple's Earnings How NOT To Gamble On AAPL Earnings
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