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Two Trades That Went Terribly Wrong

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Why you should never play earnings.

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Judgment Day

As I sit in a downtown Manhattan courthouse waiting to perform my civic duty as a juror, I'm in a judgmental frame of mind. Unfortunately, I'm coming to the decision that one of the guilty parties is none other than myself.

Granted -- they're mainly crimes against myself, but that doesn't mean they go unpunished. Topping the list has been my consistent and flagrant failure to follow some basic trading rules.

Don't Play Earnings

While it's impossible to completely avoid earnings reports, unless you're willing to dismantle and clean out all positions prior to each company's reports, it's probably not advisable to purposefully set up a trade ahead of release. I've long and frequently maintained that playing earnings isn't wise in that there's typically little edge and the number of variables reduces the trade to a simple gamble.

First you have to figure out if the company will meet or beat the estimate. Then you need to decide how investors will respond. Has the stock already run up and will it therefore be a sell-on-the-news? What's the tone of the overall market? And lastly, if you're using options, you need to calculate what magnitude of a move the implied volatility had priced into the options, and then estimate where IV and the stock will be after the report.

I'm guilty of being involved in 2 earnings plays this week. One was specific and premeditated, and even though I was wrong, there's no damage. The other was simply sloppy work and is proving costly.

The former was in Akamai (AKAM), in which I set up a moderately bullish calendar spread of buying the September $20 calls and selling twice as many of the August $21 calls. Thanks to the fact that there was a skew in the pricing ahead of the earnings, the implied volatility of the August calls was pumped to 62% compared to just 53% in September. And of course that I did it as 1x2 ratio, the position was actually done for a small credit. This means that even though the stock might plummet 20% today, it's still not losing any money. But that doesn't mean playing the earnings was the right thing to do. What if the stock had jumped 20% on a good report? I'd be net naked calls and I'd be steamrolled with a large loss.
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No positions in stocks mentioned.

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