Active-Trader - Anatomy of a Trade

Welcome back, Active Traders.  We had a perfect storm of market action this past week.

After many months of dropping hints, the European Central Bank or ECB announced a massive amount of Quantitative Easing - where they basically create billions of Euros out of thin air and buy up all types of debt securities.  This has the effect of driving up the prices of those securities, and driving down the yields, which forces money into stocks.

Europe as a culture (particularly Germany) has strong cultural biases against this type of action with generational memory of hyper-inflation leading up to prior world wars.  But with the US economy firing on all cylinders,  the dollar rallying and oil prices plunging, they could no longer deny that it was working.  So they followed the path of the US Fed who completed a round of QE late last year.

The markets loved this of course and it sparked a huge rally across the board, particularly in Europe and Emerging Market Equities.  By comparison, international equity ETF's EFA and EEM are up 0.85% and 3.74% respectively versus DIA and SPY which are both down on the year. Emerging Markets have a lot of catching up to do after several years of under-performance.

Now let's go from the macro level down to the micro and look at an individual trade able - Netflix. NFLX reported earnings on Tuesday and I approached in my standard fashion - selling an iron condor outside the expected move.  Specifically, I sold the 302.5/305 385/387.5 iron condor for a credit of 1.03, max loss of 1.47. This trade had a skewed risk to reward ratio, but since its outside the expected move, has better than even chance of going max profit.

What happened next was unexpected, NFLX surprised to the upside and exceeded the expected move.  In no time at all the stock was trading at 390 and my condor was a max loss situation.  I did not immediately reverse my position however, somewhat skeptical that this move outside the expected move would last.

Well the stock did nothing but trade up, and it settled close to 415 and hung out there for a while. But it edged ever higher and I finally got long and bought the next Friday 410 call at 15.6.  The stock moved steadily higher and closed the day in the 428 area.  I went out long expecting a pop up into the open the next day.  We didn't get it, but I ended up closing the call out for $19 so I took a decent profit on it.

Friday came around and the stock attempted a sell-off, but it didn't materialize and the stock quickly recovered the 430 area and hung out.  I was expecting the 432 area to be resistance since there's the 261% fire line at 432.47 or thereabouts.  The stock traded up and then back down and headed ever higher.  So I went long the next Friday 420 call for a debit of $15 and flipped it out later in the day for $20.  So with a profit of 3.4 on the other trade and 5 on this is a total of 8.4 profit not counting commissions overall I came out ahead on this trade in a lemons to lemonade fashion

Now let's examine how John Carter traded it.

He started off with an iron butterfly, selling the at-the-money 345 puts and calls, and buying the 300 put and the 390 call as protection.  Overall, the trade had a max gain of about $4000 and a max loss of about $5000.

Carter had the same outcome as me, a max loss on the initial trade.  But what he did next is what makes the difference, so read on.

Next, to make up for the loss, he sold 15 of the 395/400 put credit spread for a credit of 1.2 bring in a total of $1530 to make up some of the 5K loss.  Next, he bought 10 of the next Friday 405 calls at 14.20 and sold 5 of the 425 calls and the 430 calls against it. Those options basically doubled and he made over 10K on that trade and easily wiped out the initial loss.   Although as the stock moved higher, he would have had to scramble to buy back the 425 and 430 calls at a loss since the stock rallied into the close Friday.

The real take away is how Carter handles adversity.  His initial idea failed, but he traded around that and managed to come out ahead.  In my case, I was afraid of compounding one losing trade with another.  It took me about 25 points of price movement (from 390 to 415) before I finally changed directions, while Carter did it much sooner.  In either case, Carter's ability to build a position as the price action evolved (and in the middle of trade) is what gave him an advantage.

But clearly part of Carter is rubbing off since I am:

1) Selling premium to bring in income
2) Buying Delta 0.7 puts and above for directional positions
3) Giving myself the give of time and buying the next week options for longs while selling this week's premium for shorts.

I've come a long way, but it still feels like baby steps.

Have a great week ahead.