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Options Theory: How to Be Wrong and Still Make Money – EEM Edition

September 20, 2018

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Options Theory: How to Be Wrong and Still Make Money - EEM Edition

Is there anything more satisfying than being wrong, yet still making money? No sir! To illustrate how such a feat is not only possible but probable (with the right management techniques), I’m starting a new series here at the Options Theory blog. The title will be as  you see it above “How to Be Wrong and Still Make Money.”

This will be a monthly feature where I chronicle a trade that ran amiss but ultimately resulted in a profit. It will be a bet full of promise and potential that ended up falling flat. The lesson will be how I used a bit of magic to lift it from the ashes and thereby steal victory from the jaws of defeat.

Today we’re looking at a naked put play in EEM. That’s right. I went bullish in emerging markets, an area whose largest component is China – the country that Wall Street loves to hate of late.

There are three keys to my management magic: scaling, patience, and proper sizing.

An Atrocious Entry

Our tale begins on August 29th. EEM had recently popped above the 50-day moving average and appeared on the verge of breaking above the descending trendline that had kept a lid on it since January. Since I frequently deploy cash flow trades on EEM and hadn’t yet pulled the trigger on any October positions, I decided to dip my toe into the water with a partial batch of naked puts. I didn’t want to miss out on my monthly play if EEM was going to rip higher.

So, with EEM trading at $44, I sold the Oct $42 put for 46 cents.

And then, China punched me in the face.

EEM got monkey hammered for five straight days, falling to $41.50 on September 6th. My poor short puts tripled in value and moved ITM slightly. Here’s where the patience, positions sizing, and scaling come in.

First, cash flow plays require patience. I reasoned EEM would eventually rebound and I wanted to be there to collect when it did.

Second, the reason I was able to exercise patience and let the volatility play out is that I position sized properly. The first puts I sold for 46 cents were only one-third of what I consider a full size.

Third, with EEM now oversold and my short puts worth $1.30, I thought it was appropriate to scale-in to my second batch. I was filled at $1.27, thus raising my average credit from 46 cents to 86.5 cents (($1.27 + 0.46) / 2)

A Slightly-Less Ugly Entry

I’d love to say I nailed it with that second entry but I whiffed again. EEM fell three more days before finally bottoming on September 11th with a lovely little piercing pattern candle formation. I didn’t end up deploying the third tier because by the end of the day my Oct 42 puts had returned to close to the entry price ($1.27) for my second tier.

Then, as expected (8 days earlier, ahem) EEM bounced. Yesterday I peeled off the 2nd tier at 77 cents to lock-in a gain of 50 cents per contract ($1.27 – 77 cents). And with today’s pop, the put value has officially returned to my original entry of 46 cents.

Could I exit now and break even on the first tier? Sure. Or, I could let it ride and attempt to get closer to my original target of 5 to 10 cents.

The morals of the story are:

A) I’m an idiot with terrible timing but

B) It didn’t matter because

C) I know how to scale-in and use volatility to my advantage and

D) I’m patient and

E) I position sized properly.

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4 Replies to “Options Theory: How to Be Wrong and Still Make Money – EEM Edition”

  1. Avatar RyanThebo says:

    Thanks for sharing. The scaling in is something I will have to keep in mind when approaching trades that have a lot of volatility. At the first entry would it have been better to have waited for the price to close another day above the MAs? From looking at your trade I do see it closed 3 days in a row above the MA prior to your first entry point. Or would you view this as one of those trades you just write off as a fluke in market conditions?

  2. Avatar marcrosenblatt says:

    Why not place these trades as spreads to control risk?

  3. Avatar AbidRahnaman says:

    Great reminder Tyler, thanks!

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