Of the many ways of viewing risk, two primary approaches are noted:
[1] Target mediocre to low rewards in expectation of profiting regularly and often
[2] Target relatively high rewards while recognizing that profits will be banked less frequently
The trader who targets approach 1 believes the probability of an obscure event happening to derail a position is so low that entering the position frequently will yield handsome returns. While the trader who targets approach 2 dismisses the statistical thesis on which trader 1 relies, recognizing that on any given day the market can do just about anything!
For example, WellCare Group (WCG) dropped 75% of its value in about 2 trading sessions recently when surprising news was reported. A trader who had a low reward/high-risk position in play (perhaps an iron condor) perceiving it to be a high-probability play might have relied on historical statistical information to justify the entry of a trade but that didn’t help whatsoever when the stock blew past the put strikes!
Similarly, a trader that attempts to pin the strike is often engaging in a high-risk game of russian roulette. An account can literally be blown out of the water if the play goes wrong! Let’s take a look at Google as an example.
Google is famous for having its strike pinned on expiration day. It happened in August, it happened in September and then came October. For those of you that love the play, October was absolutely the wrong time to play ‘pinning the strike’ with Google. Google, in fact, appeared to be holding steady for much of the day but in the last half hour dropped 5 points quickly. But why was it a wrong time?
The first obvious reason not to play the pinning game in October was earnings had been announced the day before. The rule to which I typically adhere is to stay with a trend and stick with a pattern UNLESS the stock is about to report earnings (or is a biotech stock – they can be crazy like a fox!). Earnings can derail any technical trend in the blink of an eye so don’t succumb to the technical purists’ argument that all trading decisions should be made simply in context of the chart. Charts are helpful and are necessary but certainly don’t offer sufficiency when making trading decisions.
The other factor that worked against the Google trade in October was the market volatility was reaching relative extremes. The NASDAQ dropped a full 75 points that day! In such an environment it is very dangerous to bet on a stock staying within a single $1 range or $2 from its strike price.
Let’s do a quick analysis. If you entered a trade to optimize what you believed would be a pin on expiration day, you could choose an iron butterfly. This is simply a combination of a bull put and a bear call, whereby both short options have strike prices at-the-money (stock price = strike price).
If you could take in $0.60 credit from each credit spread, the result would be a $1.20 credit to the account with a maximum risk defined as the maximum difference in strike prices minus the credit received. Typically a 10 point spread works for Google iron butterflies so this would mean $8.80 of risk. If you were the type of trader who had spotted Google getting pinned 9 times out of 10, you might figure this is a risk worth taking.
Usually the more confident we are, the more risk we take and that is where the danger of this strategy lies. For a 10 contract lot, the maximum reward potential is theoretically $1,200. In practice, it is typically lower due to slippage when closing the positions at the end of the day. (Besides, the last thing you want are short calls or puts assigned in the money on a stock like Google over expiration weekend!) . The risk, however, of this same position is $8,800. That’s $8,800 lost in seconds if the stock drops a strike in the last few minutes. Now, it doesn’t happen often but in October it dropped half a strike in seconds and in November, you can see the stock rose a few points at the end of the day when it seemed as if it would hold its strike.
This left very little opportunity for aggressive traders to play ‘pin the strike’. In the early part of the day the stock bounced down and up like a yo-yo. Although it settled intra-day there was a short period of time when a trader could have garnered $4-$5 of credit on an iron butterfly. The trader who waited would have received substantially less just a couple of hours later and ended the day with a losing trade.
If you are considering the Google play, one of the best times to dive in is after the first 20-30 minutes. Rather than playing the low reward/high-risk iron butterfly game where your timing has to be near perfect and still offers little guarantee of a handsome reward, why not consider playing the volatility early on in the day? Google often moves aggressively in one direction early on in the day, reverses hard within the first half hour to hour and then settles. It is during this first down trend that you can look to enter aggressive long options betting on the reversal that typically occurs. The advantage of the play is that the risk is fixed and the reward potential is relatively high, often in the order of a few hundred percent for a day! You would, of course, have to exit soon after trade entry assuming the reversal did occur because time-decay is rampant on expiration day and if the stock stops moving, the premium erodes FAST.
Both plays listed are aggressive in nature. But, if you are going to choose between high risk and low reward, or low risk and high reward, it seems obvious which is preferred. If you get the high-risk, low-reward trade wrong you could lose a substantial portion of your entire trading capital whereas if you deploy only profits from winning trades into the lower-risk, higher-reward trade then the most you could lose is the debit spent. Choose wisely!
OptionSage
