Lions on the Beach


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In Ernest Hemingway’s Old Man and the Sea the aging Santiago dreams about lions on the beach, a metaphor that captures an old man’s nostalgia for his youth. An old man myself, I dream of aircraft cockpits and the dizzying array of gauges facing me when I first learned to fly jets. I wondered then how I could keep track of all those dials. My instructor gave me a single-line answer: “one at a time.” It’s simple, but profound advice–especially in our multi-tasking lives. Parents, teachers, and family elders had told me the same thing in other contexts, but I needed to hear it again.

Trading options, like piloting a plane, is a complex task with many facets. The lessons life has taught you will all come into play as you learn to trade, and surely somewhere along the way you’ve learned that doing anything well requires singular focus. In trading, you have to bring that narrow focus to various facets of every trade. Today we’ll bring it to our short bull vertical on LULU.

On Friday, we decided to trade LULU based upon the market’s positive after hours response to its earnings report. We didn’t closely examine how well the performance of the underlying supported any further entry criteria, which was probably reckless. We received a favorable fill on our order and it was soon tempting to close the trade at considerable profit, but we held onto it rather than logging a day trade.

Every morning I check my open trades to determine if they should be closed. One way of performing this analysis to answer the question, “Would I still enter this trade under the current circumstances?” This question requires an articulation of our criteria for entering a trade.

Our first consideration in entering a trade involves the selection of an underlying issue. We were drawn to LULU because of its earnings report, but other criteria can also be important. I like to seek equities that have higher historical volatility than implied volatility. I like the current implied volatility to be higher than it typically has been, but I also like implied volatility to be on the decline. Price action is also important, and here I rely on levels of support and resistance visible over the last 3-6 months on one-day candles. If the issue significantly satisfies my criteria, I seek out contracts on the option chain that have tight bid-ask spreads, a high probability of success, and present the opportunity for return on risk that exceeds 1% per day. Future posts will explain why these are my criteria. Many successful traders find fortune with other criteria. You’ll have to develop your own criteria.

We’ll begin our consideration of LULU by looking at this morning’s chart.

LULU 30 Minute Candles From Before Through After Release of Earnings Report.

In the chart above, the blue and red circles mark the release of LULU’s earnings report. Over the holiday weekend in after hours trading we’re seeing some retracement in share price, specifically a decline of about a third of the gain realized in Friday’s trading. At the close of option trading on Friday our unrealized gain on our short put vertical was at $156, 82% of the max we could receive. Given LULU’s decline over the weekend, we can expect expect to see that profit fall as trading begins this morning, so I”m submitting a closing order before the market opens. Generally, I like to reach 80% of max gain, so I’ll price the closing order at that level. The credit we received for the trade was $188. Eighty-eight percent of 188 is about $150. We’d achieve that profit if we bought back our trade for $.38 per share. Another way of looking at this transaction is that when we opened the trade, we sold the spread for $1.88 per share. Subtracting our $.38 buying price at close yields a gain of $1.50 per share.

I’ll update this post later today.

The market opened six minutes ago and we closed LULU for $.33. Our profit was $1.55 per share, $155 for the trade. We paid $1.90 in fees for a net profit of $1,53.10. The time from open to close for the trade was four days, three of which were over the holiday weekend. Our return on risk was well over 200%.

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