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On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief." Source: Business Insider So what’s a Thanksgiving turkey investment, and how can we avoid them? From my experience, investments that blow up have several things in common. Excessive leverage. There’s no strategy so good that an excessive amount of leverage can’t make it bad. This is the number 1 mistake I see, by far. Exotic, highly complex, strategies. Don’t assume that it’s ok if you don’t understand it because you’re sure the manager does. This isn’t always the case...trust, but verify. Discretionary Management. The problem with a strategy that relies on the discretion of the manager to determine when to buy, when to sell, and how much to buy and sell is that you can’t backtest it. More on this next. No long-term track record or backtest. A track record or backtest isn’t bulletproof, but it can at least give investors an idea of what the past would have looked like. The good, the bad, and the ugly. If a strategy doesn’t have a track record, at least require it to have a long backtest through a variety of market conditions. If excessive leverage was being used, the backtest would likely show how the strategy would have failed during a bad period for the strategy. No quantitative measurements. This ties in with number 4. As an experienced quantitative investor who has looked at and performed thousands of backtests, I can usually tell within seconds if something doesn’t pass the smell test. Statistics like CAGR, Standard Deviation, and Sharpe Ratio can quickly tell you if things look right or not. As Cliff Asness of AQR says, “beware of the 3 Sharpe strategies.” Basic intuition. Everything I’ve said about quantitative data is important, but so is basic qualitative intuition. Does the strategy make intuitive sense? Since there’s always someone on the opposite side of a trade, what risk are you being compensated to bear? If the strategy can’t be explained as a logical risk premium, it’s more prone to be a data-mining artifact that either won’t work at all going forward in time or will eventually stop working due to the curse of popularity. A Hedge Fund or newsletter. This is anecdotal, but it just seems that the media headlines of a blowup usually come from hedge funds and newsletters where regulations are low or non-existent. But this isn’t always the case, and I’m involved with both hedge funds and newsletters myself so it obviously doesn’t mean avoid both at all costs. Just be careful and use common sense. It’s been said that if you can’t spot the sucker at the poker table after 30 minutes, it’s probably you. When it comes to making financial decisions with your hard-earned money, it’s best to maintain a healthy dose of skepticism. Hopefully the 7 points from this article can help avoid your money having the same fate as your next Thanksgiving turkey. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios. Related articles Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? How Victor Niederhoffer Blew Up - Twice The Spectacular Fall Of LJM Preservation And Growth James Cordier: Another Options Selling Firm Goes Bust
Earnings Straddles: the Ultimate Protection Our followers already know that buying pre-earnings straddles is one of our key strategies. I described it here. The idea is to buy a straddle (or a strangle) few days before earnings and sell just before the event. IV (Implied Volatility) usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. While we use this strategy on a regular basis, it is not among our most profitable strategies. During periods of low volatility, it usually produces 3-5% return per trade (including the losers). To put things in perspective, even 3% return is not that bad. The average holding period of those trades is around 5 days, so 3% return translates to 219% annual return. If you traded 40 straddles per year and allocated 10% per trade, those trades alone would contribute 12% to your account. Considering the low risk (the straddles rarely lose more than 7-10%), this is a pretty good return. But this is where it really gets interesting: I consider those trades a cheap black swan protection. If IV goes up sharply followed by the stock movement, this is where the strategy really shines. It can provide a really good protection to your options portfolio in case of sharp moves. Examples Lets take a look on few real life examples of trades that benefited from market volatility. Entered HPQ strangle on August 3, 2011, exited on August 8, 2011 for 109.7% gain. Entered DIS strangle on August 3, 2011, exited on August 8, 2011 for 107.1% gain. Entered CRM strangle on August 3, 2011, exited on August 8, 2011 for 101.7% gain. Entered AKAM straddle on July 23, 2012, exited on July 26, 2012 for 38.9% gain. Entered FNSR straddle on March 6, 2013, exited on March 7, 2013 for 24.2% gain. Entered MSFT straddle on June 24, 2014, exited on July 17, 2012 for 35.4% gain. Entered QIHU straddle on August 19, 2015, exited on August 19, 2015 for 22.9% gain. To be clear, the returns from 2011 can probably happen once in a few years when the markets really crash. But if you happen to hold few straddles or strangles during those periods, you will be very happy you did. Summary To be successful with this strategy, you need to know what you are doing. Not every stock works equally well. There are many moving parts to this strategy: When to enter? Which stocks to use? How to manage the position? When to take profits? If used properly, the pre-earnings straddles can provide decent gains during periods of low to medium volatility. But at the same time, they can provide excellent black swan protection. Are you familiar with another way to get black swan protection that costs you nothing - in fact, it even produces some gains? I'm not. Related Articles: How We Trade Straddle Option Strategy Buying Premium Prior to EarningsCan We Profit From Volatility Expansion into Earnings Want to learn more? Start Your Free Trial