After yesterday's close, I slapped a post-it on my screen with the words "earnings" and a ghostbuster circle slash through it. This was my initial action after watching Deckers Outdoor (DECK) soar 20% following a better than expected earnings report. Yesterday, before the report, I established an at-the-money $58.50/$52.50 bearish put spread for a $2.55 net debit in weekly options for the OptionsAlert portfolio. This resulted in a 100% loss in a single day. I can accept that. Many options positions expire worthless. But there were several things I did that were less than acceptable. Let's see if I can identify what they were and hopefully avoid repeating them. And then I can take the post-it down and go back to making selective and intelligent earnings plays as a legitimate way to boost alpha.
In a previous article, we covered the anatomy of a winning trade using Costco (COST) as an example. (See here.) But, we usually learn more from our mistakes. With that in mind, let's see what I did wrong in this Deckers trade.
Some of the mistakes fly right in the face of sound concepts that I outlined in this article, specifically all the moving parts and pricing variables one needs to consider. First and foremost, I did not have a discernible edge, neither in terms of direction nor in terms of options pricing.
I became bearish on the theme that consumer soft goods, particularly fashion apparel, has been very weak. Deckers, the maker of UGG boots and Teva sandals, seemed primed to suffer from pulled-in purse strings. But I should not have hung my hat on a simple macro trend for the basis of a single day trade off of an earnings event. Instead, I should have looked at more data, like the numbers below that I looked at but ignored.
- The stock had already sold off some 14% from its October 1 high and was now at the $57 support level. I don't know which came first, but this was coupled with the reduction of analyst earnings estimates over the past 60 days by an average of $0.05 from $0.78-0.72. The company delivered $0.95 a share, mostly on margin expansion as revenue decreased 13% year-over-year. The point is bad news was already built into the price.
- Short interest had increased over the prior 30 days and stood at a whopping 29% of the float, and the stock had a days-to-cover ratio of eleven. This was not just kindling. It was the gasoline on which the earnings report sparked the fire. In this type of market, be very careful shorting heavily shorted stocks.
- The options were neither cheap nor expensive. They were pricing in about a 5% move, which was slightly below the average move in the prior six quarters but was also a pretty healthy premium above the 20-day historical volatility. So, on the whole, they were "fairly" priced. This was the reason I chose an at-the-money spread, thinking the move would not be outsized and a spread would mitigate the impact of the decline in implied volatility that comes following an earnings report. This might seem reasonable, but in retrospect, the strategy was wrong.
- The risk-to-reward of the spread was 1:1. This is not good given the above information, and I had no directional advantage. So, basically I was flipping a coin on a coin flip.
Options are all about tilting probabilities in your favor. I did not do that. The takeaways are two-fold. The first is make sure you look at all the variables. Secondly, if you choose to move forward, use a strategy that has a good risk-to-reward profile, whether that be a butterfly, some out-of-the-money spreads, or even an iron condor with its limited risk.