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  1. Like a sexy gal that can cook or an inside source at the racetrack, an actionable option strategy prior to an earnings release is something that traders know must be out there, yet it remains elusive. Most investors looking to capitalize on an earnings beat or miss simply buy calls or puts. Some of the more sophisticated speculators even get long both a call and a put (straddle/strangle), thinking that if the stock moves enough one way or the other, they'll come out at least a little bit ahead. Limited Risk – High Reward The allure of only being long calls and/or puts is that a trader knows their maximum risk as soon as they enter the order. If a call on Apple costs $100, then $100 is the most you can lose, plus you have the chance to "rake it in" if Apple moves significantly before the option expires. Therein lies the trouble with most long-side option strategies prior to earnings announcements...since no one knows what the earnings report will hold, or how the underlying stock will react; the demand for options goes up markedly before the announcement. Both speculators and shareholders looking to insure against volatility are clamoring for options which dramatically increases the premiums, making puts and calls overpriced. Being the Bookie Everyone knows that taking bets is more profitable long-term than making bets. Especially if the wager has very favorable odds for the house. This is exactly what overpriced options are for the seller – a game that stacks the deck against the buyer. In general, immediately after earnings are released, the demand for - as well as the volatility premium built into - calls and puts, evaporates. Even those that theoretically have both upside and downside covered find it difficult to profit once that "premium of the unknown" is gone from their asset. So the obvious solution would appear to be: become a seller of options. If only it were that easy! Unless you have the bottomless pockets of a Goldman Sachs, the unlimited risk part of being a naked option seller will be too much for you and your broker's heart to take. Credit Spreads In order to take advantage of the inflated premiums in the option market prior to an earnings announcement, yet mitigate the risk of selling uncovered (naked) puts/calls, the go to strategies are "bull put credit" and "bear call credit" spreads. Rather than getting bogged down in the stock XYZ trading at $50 - type explanation, I'll leave it to a google search for those wanting the nuts and bolts of how to construct the option spreads mentioned above. The focus here is how to maximize the profit from these spreads and that is accomplished in the unwinding. Unwound Once the earnings report comes out and the market is digesting and reacting to the numbers, option prices revert to a more realistic reflection of future prospects. This allows the trader to unwind his pre-earnings position and cash in on the uncertainty that was prevalant prior to the announcement. Does it work every time? No. Does it provide enough profit to get an address on easy street if it's all a trader does? No. But it works often enough and provides a boost to the bottom line to make it a worthwhile play to investigate further.
  2. Hard way to make an easy living. Trading: It's simple, but it ain't easy.
  3. Here is what's going through my mind as I enter a stop order: "this is the price where the market is not acting as I thought it would and I must get out and re-assess" (initial stop) "this is the price where the risk outweighs the potential increase in profit if I stay in" (trailing stop)
  4. A stop that is not entered cannot be hit. Those nine words, while absolutely true, cost me a mountain of money back when I was a rosy-cheeked youngster who was about to set the trading world on fire and rip the market a new one. After numerous painful 'setbacks' - to put it diplomatically - I discovered another, much more profitable truth: taking small losses is the cost of doing business in the world of professional trading. I know what you're thinking: another 'cut losses short and let winners run' article...thanks Captain Obvious. I concur; money management and preservation of capital are the most boring topics in the trading universe. So I'll assume that anyone reading past this point uses stop loss orders and is mainly interested in how to optimize them. First, a quick clarification. The stops I'm discussing aren't the ones that some traders enter before a new trade is filled 'just in case'...just in case the power goes out or the internet/computer goes down before they can get their initial stop order in. I'm strictly speaking of initial and trailing stops and the most profitable spots to place them using price bars. The initial stop loss is entered as soon as you're executed on a new trade. If the trade goes against you, you're stopped out at that price and it's on to the next set up. If the trade works in your favor, the intial stop becomes a trailing stop and the price is moved along to protect profits. Bars, Swings and Trends If successive bars are making higher highs and higher lows, that's an upswing. If successive bars are making lower highs and lower lows, that's a downswing. When successive swings are compared, if they are in a pattern of higher highs and higher lows (or lower highs and lower lows), that is deemed an uptrend (downtrend). With those definitions out of the way, using price bars to set stops is pretty simple. In an uptrend, the market is making higher swing highs and higher swing lows. Within the upswings, the individual price bars themselves are typically up bars. The idea is to set the stop loss order under the lows of the up bars in an upswing, because if the pattern of up bars is broken, it's not going up any more. In a downtrend, the market is making lower swing highs and lower swing lows. Within the downswings, the individual price bars are typically down bars. The idea here is to set the stop loss order above the highs of the down bars in a downswing, for if the pattern of down bars is broken, it's not going down any more. Dropping Down Finally, we get to the part about saving ticks and increasing profits. Setting the initial stop order can't really be tweaked all that much. I hate to be the one to tell you, but you're always going to have a small percentage of your trades get stopped out by a tick or two and then reverse and go to target without you. It's one of those cost of doing business things and it's inescapable. You just have to set the initial stop order as illustrated above and take what comes.The good news is that once the position moves into profitability, there are tricks of the trade, so to speak, that will add to the bottom line. Dropping down to the next smallest time frame on your chart instantly increases profits by getting you out of your winning trades without leaving as much on the table. If you're trading off the 1 hour chart, click it down to 30-minutes. If you're a 5-minute bar player, down to 3-minute, and so on. The pattern of higher or lower swings will be broken sooner on the smaller time frame and save you a few ticks in getting out. This also allows you to ignore inside bars as far as moving your stop, without increasing your risk. Expanded Range I'd be remiss if I didn't touch on my experience with expanded range bars as they pertain to stops. Using whatever measure you'd like; be it an indicator like ATR (Average True Range) or a ruler held up to your screen; when you are in the midst of a profitable trade and trailing your stop along and a bar starts forming that is significantly larger than normal, tighten that stop. This is usually a sign that the move in your direction is over, at least temporarily, and you might as well take all you can rather than letting it come all the way back to your stop. You can always get back in.
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