Saturday, 21 May 2016

More on LB / Thoughts on Option Risk & Trading

I've posted a couple of times this week on an idea I had regarding speculating against prevailing sentiment in L Brands into earnings.  I still believe the overall idea is valid.  The job of the speculator is to assume risk and get paid for assuming risk.  The problem I had was twofold, 1) the mechanism I chose to speculate with lost money, and 2) I bought into too obvious a set-up.  More on this shortly.

This is all ok as long as I keep position sizing small enough to not matter, and debrief the mechanics of the trade and understand why it went wrong.

Trading is just about the most frustrating job on the planet.  You can have the right idea in theory and still get blasted.  It's like death by 1,000 paper cuts.

It's a constant process of grinding it out, and the hardest part of evaluating wins vs. losses is not letting wins (or losses) get to your head and influence your process.  Often, wins are a result of dumb luck.  I want to distinguish for a moment between trading/speculating and investing.  Sometimes there is a huge difference between the two.  Other times, the lines get obscured.

Over time, I've become convinced that many participants are lucky and don't realize it.  Arbitrarily picking a basket of stocks and holding those stocks during a rising market may have more to do with luck and good timing than exhibiting any real skill in stock picking.  The real test of mental fortitude occurs when the opposite occurs.  When that basket exhibits a significant drawdown, how does the participant react?  Does the participant abandon the steadfast principles of acting the part of a long term investor and revert to selling parts of his portfolio to "minimize risk"?

Back to LB.

On Wednesday May 18th, I bought one June $67.50/$70 call spread for a net dr. of $.60 in anticipation that earnings would surprise.  $.60 seemed cheap in the context of overall acceptable risk in my IB account.

I drew the following trend-line on a weekly chart anticipating that it would hold and provide support:

Here's the daily set-up (through Wed May 18th, b4 earnings):

And here's the daily set-up post eps (on Thursday):

I commented above that I bought a call spread into too obvious a set up.  The more I think about this, the more I believe that what appeared obvious to me should have been a warning to me.  When a set-up appears juicy, it probably means that other participants are observing the same set-up and positioning themselves all on the same side of the set-up.  Sound familiar?  This is really no different than sports betting.  If the Patriots are favoured vs. the Broncos, it gets more costly to bet on the Patriots vs. the Broncos.

If a set-up appears juicy, I believe the correct approach is to either stand aside and observe the reaction, or to have an anticipatory order in the market based on a max "psychological" pain result.

Max pain would have been a further move down to even money support at $60.  For less risk of putting on the June $67.50/$70 call spread, I could have entered a good to cancel order for the June $65 call at $.40 in anticipation that all other participants were positioning themselves for some sort of mean reversion from oversold conditions.  When the bounce did not occur on Wednesday, selling pressure likely became exacerbated by virtue of all participants on the wrong side of the trade unwinding their losing positions.  On any subsequent bounce, I could have then sold the $67.50 call against the $65 assumption of risk for even money in order to put the call spread on for free.  Heads I cover my entry risk, tails, I make $2.50.

Here are the June calls courtesy of yahoo finance from Friday:

The more I participate, the more I believe that trading is akin to a giant game of chess, trying to see a couple of moves ahead while minimizing risk and maximizing returns.  And it is not easy.  It is extremely counter-intuitive.

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