SteadyOptions'  Instablog

Please find below the April 2013 update from SteadyOptions.

1. Performance
April was an excellent month for SteadyOptions. We closed 16 trades in April, 13 winners and 3 losers. Total gain in April was $2,032 based on $1,000 allocation per trade. Assuming maximum of 6 trades open (the average number is lower), that's 33.9% non-compounded gain. Most Fund Managers don't make those returns in a full year.

The YTD non-compounded ROI is 58.7% based on the same 6 maximum trades. Check out the Performance page to see the full results. Please note that those results are based on real fills (excluding commissions), not hypothetical performance or "profit potential".

2. Expanding the trades scope

We continue expanding the scope of our trades beyond the earnings trades. We closed three VIX trades for ~30% gain each. We also closed three pre-earnings calendars (AAPL, IBM and NFLX) for double digit gains. Those trades provide nice balance to the portfolio in periods of lower IV. The earnings straddle/strangles performed very well too, including AMZN, CMG, QCOM, SNDK and RVBD. GLD straddle was the only sizable loser - we just held it for too long. We also started trading VXX. We will continue refining those strategies to get better results. This gives members a lot of choice and flexibility. I also encourage members to trade what they feel comfortable with.

3. Limited new membership
The membership is now open to new members for a limited time. I invite you to join us.

Kim

Despite a healthy beat and dividend hike, shares of Apple (AAPL) are slightly down in after hours trading. They have lost now almost half of their value in the last 6 months.

During 2012, I warned several times that Apple has gone up too far too fast. When the stock was going up almost every day for no visible reason, I asked a simple question: what do we know today that we didn't know a month ago?

I won't go into models, forecasts, P/E ratios, DCF analysis etc. I'm sure there will be enough gurus doing just that. Most of this mumbo jumbo stuff is useless anyway - the markets will do what they have to do and will usually laugh at your analysis. Instead, I would like to offer some analysis how you could see the warning signs and what are the lessons from the American darling's crash.

Warning signs

When the stock has risen to $705, you could find plenty of warning signs. For example:

1. Apple's value was more than 4% of the U.S. GDP.
2. Options Implied Volatility jumped from 19% to 41% in a matter of few weeks with no significant news.
3. You could make almost 50% in one week trading a delta neutral butterfly spread. Those returns are possible only with highly speculative stocks.
4. Pretty much everyone was bullish on Apple. If everyone is bullish and already has purchased the stock, who is left to support further stock increase?
5. The market was pricing the good news only and ignoring all the bad news.
6. According to Forbes, some of Apple's insiders dump the stock.
7. The positive sentiment reached extreme levels.

The Forbes article is especially interesting. The columnist argues that:

"Apple cultists may want to take notice that the top brass of Apple clearly does not believe that Apple stock going to $1000 is a sure thing. Blind faith is the hallmark of cultists. "

It also quotes an email from an Apple's cultist:

"You are wasting your time here……. Other analysts on AAPL are all silly? You are smarter? A nuclear physicist, so what? Apple will be above $1000 soon, no matter what you said……. You took profit at $360 and $525, shame on you."

Please note the definitiveness of Apple going to $1000 in the above excerpt.

Some people argued that the stock will get more support from dividend funds that were restricted to own it till now. I personally doubted it then and I doubt it now. The stock often moves up and down more than the entire year's dividend in just a few minutes. Most of the dividend funds don't want to own that kind of volatility.

History lessons

Unfortunately, in most cases of parabolic moves, those who join the party late buy the shares of those informed traders and investors who have already made significant gains and are ready to move to the next target. When they decide to sell part of their remaining portfolio, then the late comers, who are usually weak hands, panic and try to sell at break-even or just below that.

The recent crash also shows the dangers of over-concentrated portfolio. Many people went "all in" with Apple thinking that the stock will just continue going up $100 month after month. Obviously they were proven wrong. No stock deserves more than 20-30% of your portfolio maximum, and AAPL is no different.

Market history is filled with moves that defy logic as the charts "go parabolic." Those moves usually have 3 things in common:

1. They go further than one would expect.
2. They never last.
3. They usually end really, really badly.

What now?

AAPL price action simply proves that there is no such thing "cannot go any lower". Is the stock cheap? Yes, some would say ridiculously cheap. But it was cheap at $500 too. Would I buy it now? The answer is no. I learned the hard way not to invest in stocks without some kind of hedge, no matter how cheap they seem. Personally, I'm implying non-directional options strategies that are designed to make money in every market. Since joining Seeking Alpha four months ago, I shared quite a few Apple trades with my readers. Here are some of them:

• The Bull Credit spread from December 13, 2011 produced a 42% gain in 6 weeks.
• The Iron Condor from January 10, 2012 produced a 28% gain in 2 weeks.
• The Long Butterfly from March 19, 2012 produced a 35% gain in three days.

Since Seeking Alpha discontinued the Options section, I cannot write options articles anymore. However, I still share the trades with my members - my last AAPL trade was a calendar spread just a month ago which made 25% in two weeks (the stock was down 5% during that time).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

When a fellow Seeking Alpha contributor Kevin O'Brian promised back in September to write an article "on Kim Klaiman's/Steady Options trading approach and why it doesn't work as advertised.", I was pretty excited. I have over 10 years of experience in the stock market. However, unlike Kevin who claims to "know basically all there is to know about options", I'm still learning. I will be learning as long as I breathe. So despite my 152% ROI in 2012, I really wanted to know why my approach doesn't work. Maybe it was all just a fluke?

The article finally came out last week, but it had nothing to do with my trading approach. It was all about my personal history with Kevin which I don't think is much of an interest to our readers. My article is really about my trading approach and how it compares with Kevin's.

First, let me be very clear: no matter what some "gurus" will tell you, no strategy will work all the time. Mine is no exception. I never claimed that it works under all market conditions, and I never claimed that other strategies won't work and mine is the only right thing to do. There is more than one road to Rome.

My approach

I described my strategy of trading earnings here and here. The strategy is buying a strangle/straddle or reverse iron Condor a few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings.

Now, few scenarios are possible.

1. The IV increase is not enough to offset the negative theta and the stock doesn't move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days, and the maximum risk is around 20-25% (except for some very rare cases).
2. The IV increase offsets the negative theta and the stock doesn't move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners, sometimes in the 50-60% range.

What I really like about this strategy is the ability to keep the losses small. The risk/reward is significantly smaller than most other options strategies. Overall, the average gain is in the 10-15% range and the average loss in the 5-10% range. Combined with decent winning ratio of ~60%, the strategy should be a winner in the long term.

In some cases, when I think that near term options are overvalued, I might also buy a calendar spread with short options expiring just after earnings.

Kevin's approach

Kevin also likes to trade earnings non-directionally, but with one significant difference: if the trade doesn't produce significant gains before earnings, it will be held through earnings. In my opinion, this strategy has negative long term expectancy because on average, options tend to be overpriced before earnings and IV collapse after the earnings will cause the trade to lose value - unless the stock moves more than implied by the options prices. I described here why I don't like to hold those trades through earnings.

Same is true with calendar spreads - if you hold a calendar spread through earnings, you bet that the stock will not move much. If it does, the loss can be catastrophic, as proved by Kevin's IBM trade.

The main problem of holding any trade through earnings is complete lack of predictability. Some trades can produce outstanding gains while others end up with catastrophic losses. If the trade uses short expiration and the stock moves less than "predicted" by the options prices, the collapsed IV will cause a very significant loss.

How position sizing impacts the overall performance

The most important point that many traders ignore is the position sizing. Even if the second strategy (holding through earnings) produces higher average gains (and I doubt it), what really matters is how much your overall account gains. When you risk only 20-25% per trade worst case, you can easily allocate 10% per trade. However, when you hold through earnings, your risk is up to 90-100%. That means that realistically, you cannot allocate more than 2-3% per trade. If you allocate 10% and you have a streak of 4-5 big losers, you have just lost half of your account. Whoever claims never having such a streak is either lying or hasn't been trading for long enough.

Kevin keeps saying that he "doesn't trade options for a 5% ROI". Let's check what 5% return can do to your account.

Assuming that you make 20 trades per month, allocate 10% per trade and make 5% per trade, your overall account grows 10% per month. Commissions will reduce it to ~7-8% per month. That's about 80-90% per year, non-compounded (while having ~40% of the account in cash). Increasing the allocation to 15% will produce 120-140% annual return while still risking only 3% per trade. I challenge Kevin to show how he can achieve a similar return with his strategy with similar level of risk. I also challenge him to show any kind of statistics for his strategy of holding through earnings.

Here is another point that many traders miss. If you have a 15% loser and two 15% winners, that's 5% average return. But if you take a 100% loser, it will take two 60% winners or three 40% winners to produce similar 5% average return.

Conclusion

To conclude, it all comes to what kind of trader you want to be. Is your goal to limit the losses or to maximize the gains? You cannot have it both ways. Higher gains come with higher risk and inevitably will produce some big losers, so the position sizing has to be adjusted accordingly. Risk and reward are closely related in trading.