A few weeks ago I wrote a post about a trade recommendation I received to open a cash secured put on IBM before earnings.
As I said in the post, this wasn’t my trade recommendation, and wasn’t a trade I entered, but I wanted to discuss it in terms of the risk management. As you know, I tend not to trade stocks over earnings, it’s too much of a crapshoot for me.
As a reminder, IBM was trading at $154 at the time, and the trade was to sell a July 28th, $150 put for around $2. The suggested stop loss was if the put rose to $4.50.
As you know, IBM dropped post earnings. Thankfully for cash secured put sellers, it didn’t drop too far, but it did open at $150 and traded as low as $146.90.
The put traded down as low as about $3.25, therefore never hitting the stop loss on the day after earnings. I was kind of hoping IBM would gap down a lot lower so I could demonstrate how stop losses can give you a false sense of security with options.
The $150 puts did end up closing at $5.98 at expiry so the trade would have been stopped out eventually per the trade recommendation.
Let’s take a look at another example using TWTR which is a stock that tanked after earnings.
TWTR announced earnings on July 27th before the market open. The day prior, it was trading at $19.61 and the August $19 puts were trading at $0.90.
Let’s assume we sold the put and had a stop loss at 2x the premium received, so $1.80.
The next day TWTR traded down to $16.50 and the puts open at $2.79 a full $1 above the stop loss. There is no way you would have been able to get out of the trade at $1.80.
This is where stop losses on options can be troublesome.
Keep that in mind next time you’re trading options around earnings.
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.