Don’t hide behind the math! That is a common phrase I tell my students seemingly on a daily basis.
That may sound quite odd coming from a statistics major, but it is one of the very important credos we traders must live by.
What Do I Mean By This?
It means, don’t let a mathematical output override common sense.
Trade Example
Let’s take an example when I was looking for an earnings play in Abercrombie & Fitch (ANF). Through my research I saw that the market was pricing about a 9% move into earnings and the average move over the past two years was about 11%. I constructed a strangle swap, looking for ANF to maintain a trading range, with favorable break even points out to about 11%.
But let’s take a look at what the actual moves on earnings were: +5.8%, +11.3%, -0.1%, -17.7%, -8.0%, -4.5%, +34.4%, +9.0%. Only three of these earnings were anywhere near the average of 11%!
Bottom Line
To try and model a scenario for this setup to regress to some predictable mean is foolish and arbitrary. I would argue that the most prudent move, if any, would have been to find a compelling directional play and take that. I did not find one so I took a pass and moved on.
