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I want to examine yesterday’s trade (PSTG bull put spread with strikes at 25 and 28). I was drawn to it because PSTG’s earnings report was published after the market closed on Wednesday, and its earnings exceeded expectations. Trading into an earnings report can be tricky and risky. These reports, which include both earnings from the previous quarter and expectations for the future have an outsized effect on share price. That often translates into high volatility leading into the report. At earnings time traders expect a sudden change in price, but don’t know if the change will be up or down. After the report’s release, implied volatility returns to more normal levels for the underlying. PSTG released their report two minutes after the market closed on Wednesday, and it inspired investor confidence during after hours trading. When the market closed on Wednesday, PSTG traded at 28.97. Just before the market opened on Thursday, it traded at 30.14.
An interesting feature of option prices is that they don’t change overnight. While orders for trades may be entered, they aren’t executed until the market opens. This means that a sharp rise in the underlying leaves OTM puts overpriced. The market will quickly correct for this situation, but it takes some time to do so. Until it does so, you may get a favorable fill on an order as we did yesterday morning.
Unfortunately, the overnight euphoria over the positive earnings report quickly wore off and the price of the underlying plunged below our short 28 strike. I closed the trade quickly to salvage the remaining gain rather than accept the risk of PSTG’s decent into unprofitable territory. I’d make the same decision again, even though PSTG began to rise in the afternoon, and had I waited until this morning to close, I’d have seen a $65 profit on the trade.
Key take-away: if you think a trade is going to lose money, close it and have no regrets.
This morning I tried to repeat the kind of earnings play described in the previous paragraph. This time it was Lululemon (LULU) with a very positive afterhours earnings report. I sold one bull put vertical for $188 net credit. LULU has continued to climb, and I could close it at max profit less than a half hour after opening it. I’m going to let this one run because, I’m not seeing the kind of quick decline in value that we experienced with PSTG. This also provides a good opportunity to talk about day trader pattern trading (DTP).
For the official FINRA (Financial Industry Regulatory Authority) rules on DTP check out their website. Accounts less than $25000 cannot exceed three day trades during any five-business-day period. A trade that is both opened and closed on the same day is considered a day trade. Brokers have some latitude in how they implement FINRA’s policy, so before you day trade, do check your broker’s policy. The DTP rules surely discriminate against small-time traders, but rules are rules, and if you dance close to them you risk stumbling over the line, and your trading activities will be restricted.
Key take-away: If you open and close a trade on the same trading day, keep track of it.
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