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Minyan Mailbag: A Rookie Mistake

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Learning from our mistakes makes us better traders.

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John,

Please explain to me how I just made a rookie mistake.I bought puts on MicroStrategy (MSTR) before the earnings last night and the stock has tanked! But i bought the Nov 65 puts and they are basically flat with the stock down 7..I obviously bought the wrong price,and should have bought 75s or 70s? Please explain why they are not moving and how my idea was right but strategy wrong.


Thanks,

Minyan Scott


Scott,

Last night the stock was around $75 and you paid $2 for the November 65 puts expiring November 18, twenty-one days from now. At $2, you paid an implied volatility of 86% (implying the stock will move 86% over the next year). This price implies that the stock will move .86 x SQRT (21/250) = 25% over the next 21 days.

After earnings, the stock is only down about 10%. So you paid an option price that assumed the stock would move much more than it did. The options now after earnings have a more realistic implied volatility of 47% and so are saying that the stock will only move .47 x SQRT (20/250) = 13% over the next twenty days.

-Succo


You simply paid way too much for these out of the money options. When the stock did not move as much as the price you paid implied, the option price declined precipitously.



Next time first estimate the maximum and minimum you think the stock can move because of earnings. Compare this to the implied volatility of the options you are buying and adjust for timing as I have shown you above. This will keep you from paying way too much for the option.

No positions in stocks mentioned.

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