Last week, I presented 5 ways to play Google's (GOOG) earnings non-directionally. The stock moved 4.06% after the announcement, much less than expected. I would like to do some analysis how those trades turned out and what we can learn from them.
A reminder about the trades described on April 4th, 2012, with the stock trading around $642:
Trade #1: Buying a straddle and selling after the announcement
For those less familiar with options, a straddle is buying the At-The-Money (ATM) call and the ATM put with the same expiration.
This strategy would do very well most of the time in the past, averaging 39.60% return. Not this time. The 650 straddle purchased at the close before the announcement and sold at the close next day, would lose about 40%. This assuming you waited till the end of the day and sold almost at the highest value. If sold before the end of the day, it could easily be a 50-60% loss. Ouch.
Trade #2: Buying a Reverse Iron Condor and selling after the announcement
A Reverse Iron Condor involves buying an Out-of-The-Money (OTM) strangle and selling a further OTM strangle. With the stock trading around $640, you could execute the following trade:
Sell GOOG April Week2 2012 630.0 put
Buy GOOG April Week2 2012 635.0 put
Buy GOOG April Week2 2012 645.0 call
Sell GOOG April Week2 2012 650.0 call
The trade would require about 1.5% move. Depending on your entry price, it would produce a 10-12% gain.
Trade #3: Buying a strangle and selling before the announcement
Buy GOOG April Week2 2012 630.0 put
Buy GOOG April Week2 2012 650.0 call
Depending on your timing and entry price, this trade would be about breakeven or a small loser.
Trade #4: Buying a straddle and selling before the announcement
Buy GOOG April Week2 2012 640.0 put
Buy GOOG April Week2 2012 640.0 call
Same result here, breakeven or a small loser.
Trade #5: Buying a Reverse Iron Condor and selling before the announcement
Sell GOOG April Week2 2012 610.0 put
Buy GOOG April Week2 2012 615.0 put
Buy GOOG April Week2 2012 665.0 call
Sell GOOG April Week2 2012 670.0 call
This was the trade that I executed for my personal account (with strikes adjusted 10 points lower, based on the stock price on Monday). The trade returned 15%, mostly due to the IV (Implied Volatility) increase. The thesis proved itself once again.
I would like now to compare Trade #2 with Trade #5. However, I will be modifying the strikes in Trade #2 and using the same strikes as in Trade #5 (about 5% Out Of The Money).
Trade #2 would be kept through earnings and require the stock to move about 5% to realize the maximum profit. If it happened, you would realize a 40-45% gain, depending on your entry price. The trade would be profitable 8 out of 10 last cycles. However, when the stock moves less than expected and doesn't reach the long strike, the trade is a 100% loser. This is what happened this time.
In comparison, Trade #5 is not dependent on the stock's post-earnings move - it is sold before earnings. Even if the price is between the strikes, the spread keeps its high value due to continuously increasing IV. It would produce an average gain of 10-12% most of the time with very limited risk. It is very rare for those trades to lose more than 7-10%.
So what is better - to have eight 40% winners and two 100% losers or to have ten 10% winners?
In the first case, your accumulative return is 120% (12% per trade). In the second case, it is "only" 100% (assuming 10% per trade). But here is the catch: Those returns don't account for position sizing. Let's assume you want to risk 2% of your portfolio per trade. In the first case, you know that you will win most of the time, but when you lose, you can lose 100%. So you can allocate maximum of 2% of your account per trade, which gives you a total portfolio return of 24%. In the second trade, you can rarely lose more than 7-10%. The maximum loss I had with those trades was around 20%. So you can easily allocate 10% per trade, which gives you a total portfolio return of 100%.
Now you see the difference? With the second trade, I can have much smaller average returns, but with proper allocation, I'm still way ahead.
So what are the lessons from the Google's earnings trades?
Earnings reaction is unpredictable.
Always be aware of the risks.
What was working in the past (even 80% of the time) will not always work again.
Always be aware of position sizing and allocate based on the maximum loss, even if this loss is unlikely to happen.
Steady and consistent is better than volatile and unpredictable.
Please trade responsibly. When you read a trade recommendation from me or any other Seeking Alpha contributor, always do your own homework. Remember: Even if the trade is presented like a "cannot lose" proposition, things can always go wrong. If you use a proper position allocation, you can live another day, even with a 100% loss.