Mistakes Were Made: My Yahoo Option Spread Trade

I’m a plain vanilla options guy.  I like to buy puts and calls and make a directional bets on a stock, knowing full well that time is my enemy.  Options are inherently risky so I’m not turned off by the ticking time bomb.  My stop-loss point is 50%.  I have found that if I don’t give options that much room to move, I often get shaken out of a position before it has a chance to go my way.  A 50% stop would make most stock traders cringe.  For me, it’s the cost of playing.  And most of the time it works for me.

But occasionally, I like to buy more complex options positions that take advantage of the option time decay, rather than be at the mercy of it.  Every smart options guy says this is the only way to make money in options – sell them, don’t buy them – because the time decay works in your favor.  But I usually regret the decision.  My recent Yahoo Spread trade was one of those trades.

I thought that YHOO would remain in a trading range over $40 per share and that the options would expire worthless.  I didn’t want to buy a call outright because I didn’t think the breakout would continue to run.  However, in case I was wrong, I wanted to cap my downside risk.

Looking at the chart below, I essentially bought 10 put options with a strike of a and sold 10 put options with a strike of b, producing a net initial credit.  This is called a bull credit spread.  Specifically, I sold $40 puts (the right for someone to sell to me YHOO stock at $40 per share) and bought a $37.50 puts (the right for me to sell YHOO stock for $37.50).  I sold the YHOO $40 puts for $1.20 ($1,200 in my account) and bought the YHOO $37.50 put for $0.70 (a cost of $700) for a net credit of $0.50 ($1.20 – $0.70= $0.50 x 10 options or $500 net in my account). 

If the stock remained above $40, I would pocket the $500 as both options would expire worthless.  My break-even point on the trade was $39.50 ($40 strike minus $0.50 credit).  As the stock moved under $39.50 toward $37.50, my loss would be the difference between between strikes of the two options ($2,500) minus my initial credit ($500).  My maximum loss ($2,000) would occur if, at expiry, YHOO closed below the lower strike of $37.50.  

Of course, we all know what happened.  YHOO missed earnings and the stock gapped down to $35 the day after earnings.  I made several mistakes on this trade.

First, I bought a Bull Put Spread even though I was negative on the market.  I essentially used the YHOO trade as a hedge because I was already positioned for a market correction.  But it doesn’t excuse the trade.  I should have stuck with my market view and used my traditional stop losses instead of "getting cute" with the YHOO play.  I outguessed myself. 

Second, although the YHOO put was 10% or over $4 out of the money, it wasn’t enough protection given the big earnings event coming up.  I thought YHOO would remain in the trading range even if earnings were in line.  I gave little probability to YHOO missing earnings outright.   Given the volatile nature of the stock, I should have realized that the Bull Spread credit of $0.50 wasn’t compensating me enough for the risk of YHOO’s stock gapping down after the earnings announcement. 

Third, the action in the stock up to the earnings announcement was worrisome.  Given the stock made an island gap formation the day after I entered the spread trade, I should have turned this trade into a Backspread.  That would have entailed purchasing additional $40 or $37.50 strike puts.  I would have essentially been betting that the stock was going to go down, not that it would stay in the trading range.  But because I was intent on pocketing the time decay on the spread trade, I didn’t act on what was obviously poor stock action. 

Finally, I have a theoretical problem with the Spread Options trade, which is why I don’t do them very often.  While it caps your downside, it also caps your upside.  I took a $2000 risk to make $500.  That’s a generally poor risk reward situation.  I like taking a $500 risk to make $2000.  That’s my traditional modis operandi.  But at the time, I thought the probabilities were in my favor. 

The lessons for this mistake I have taken away are 1) to make sure the stock is in a bullish trend before entering a Bull Spread.  YHOO was more in a sideways consolidation than a good uptrend.  2) Be flexible in trading around the core position, especially if there are significant earnings announcements coming up.  3) And finally, I let the false breakout in YHOO’s stock and the strong market cloud my risk reward decision making process.  I should have just not traded anything to do with YHOO because I didn’t have an edge in gaming the earnings announcement.  And because I didn’t have an edge, I didn’t have the confidence to turn my initial Bull Spread into a Bear Backspread when the chart turned negative.

The one big positive was that this was a relatively small position for me.  And that’s the biggest lesson that anyone can take away from my mistake.  When you trade options, be sure to never "bet the house".  No matter how great the trade looks, options will rip your heart out if you don’t use good money management techniques.

So those were the mistakes I made.  I hope you can learn from them.