What to do with a losing trade

[Kim 7,421]

Based on a few recent trades, I would like to talk about our options when it comes to a losing earnings trade.

As we know, our earnings trades are based on a thesis that IV should increase before earnings, letting us to be out before the earnings for a decent gain. What if despite all our homework the thesis didn't work and the trade is losing money?

I'm going to use our latest WFC trade for the analysis. We purchased the 33 straddle 7 days before earning for 1.44. One day before earnings, it is trading at 1.28, about 10% loss. For simplicity, lets assume that the stock is trading close to the $33 strike.

We have now 3 options:

1. To sell and take the loss.

2. To hold through earnings.

3. To convert to RIC (Reverse Iron Condor) by selling the 32/34 strangle at 0.50.

Now, the first question I ask myself: would I buy this position now? If the answer is no, then the first option is your natural choice. I would never hold a position just to salvage a losing trade.

If you hold the current position through earnings (option #2), few things can happen.

1. The stock moves 8% (the largest move in the last 10 cycles). In this case, the straddle will be worth about 2.65. Congrats - you made 84% on the original cost. The chances for this to happen are not great.

2. The stock moves in line with the average move in the last 4 cycles - 4.7%. In this case, the straddle will be worth 1.55, and you made around 8%. Not bad.

3. The stock moves 2% or less - it happened 5 times out of last 10 cycles. In this case, the straddle can be worth anywhere between 0.30 and 0.80. Congrats - you just turned a 10% loss into 40-80% loss.

Considering the fact that you will probably not be able to sell at the exact point of the maximum move, the chances are that average move in the last 4 cycles will cause the trade to end up around breakeven, give or take ~5%. However, you are taking a big chance of losing 50% or more.

Now lets check option #3 (converting into RIC). Since you sell the strangle and get 0.50 credit, you are lowering the original cost from 1.44 to 0.94. So now to break even, the stock has to move only 0.94 instead of 1.44 - that's 2.8% instead of 4.4%. If the stock moves more than $1 (3.0%), the RIC will be worth $1.00 and you will end up with a small gain. So you need smaller move, but you also limit your upside in case the stock moves big time. Plus, since we still have a week to expiration, the spread will not have the full value till the last day - what if the stock reverses by then?

We ignored one factor in our calculations, and this is the time value. In case of WFC, since we are trading monthly options, we still have a week till expiration, and the options will have some time value - however, it will be fairly small and doesn't change the big picture.

Remember we assumed for simplicity that WFC will sit on the strike? Well, right now it is at 33.40. If it stays there, the trade is also not delta neutral, in addition to all the other complications. So even if it moves 3-4% but in the "wrong" direction (down), the trade still will be a fairly big loser.

I hope you have now the correct tools to make the right decision.

[trader5563 0]

Thanks for taking the time to break this down Kim. Option #1 seems like the best move to me. Take the loss and get ready for the next trade. After all, my original attraction to the non-directional strategy was to be delta neutral and not take huge losses very often.

[Rogers 263]

Thanks for the in breakdown Kim. Maybe WFC will move enough or IV will increase enough to make the choice easy.

One additional thought on holding the monthly straddle or RIC into earnings is that the profitable leg can be sold when the stock moves (provided it does move) leaving the other leg open for a lottery ticket play or reversal play. Granted with time left before expiration even that leg will have some value.

[jr1221 12]

One thing that wasn't really addressed above...I think there was a subscriber who wondered if he should just close the position today, instead of waiting until tomorrow (last day to sell prior to earnings). If I'm in a trade that's 10% down, I see no reason whatsoever to sell it a day early. The last day is one of the most likely ones that the IV increase will exceed theta. So there's a decent chance you'll gain much of that loss back. And even if you don't, you're not likely to lose more than another 1-2%, which is a risk worth taking.

I really sleep well with this trading strategy, because I: 1) don't care which way the market goes the next day, I simply hope it goes big even though that's not always necessary either, and 2) I know I'll never wake up in the morning and log into my IB account and find a position that lost 60% overnight, which is what I saw way too often with my previous directional trading strategy. It sucks when these trades go against us but the losses aren't the type that should stir any panic, including selling before the final IV push begins on the last day before earnings.

[Rogers 263]

A lot of us here are recovering directional traders (DT) looking for something that helps us sleep at night. It is refreshing not having to wake up at 4am to see if the futures moved in my direction or not.

[cwelsh 1,496]

That's why I hate legging out of trades -- if I don't get a fill, then I toss and turn that night.

[Marco 221]

That's why I hate legging out of trades -- if I don't get a fill, then I toss and turn that night.

ah there one of my trading rules: if I lose just one night sleep over a position I close or at least reduce it the next day.