Options Trading 101: Don't Hide Behind The Math

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.

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