What Is Better: A 50% Gain Or A 15% Gain?

If this is the first time you are reading my article, you probably think: "is this guy okay?" How a 15% gain could be better than a 50% gain? Well, just keep reading.

In my article about options myths and misconceptions, I presented several common myths about options trading. I showed how you can use options in a different way than just buying calls or puts and still generate very significant gains. I also showed how many smaller winners with lower risk might be better than few larger winners with higher risk, and that it is not necessary to aim for 100% gain in each trade to be profitable.

My regular readers already know that my favorite way to play earnings is buying a strangle or a straddle a few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising Implied Volatility (IV) of the options before the earnings. I described the general concept here.

Some traders prefer to hold those trades through earnings, based on the history of the stock moves. Let's examine both ways using Cisco (CSCO) and Google (GOOG) as examples.

Here is the history of Cisco one day post-earnings move in the last 10 cycles:

(click to enlarge)

Here is the history of Google:

(click to enlarge)

As we can see, Google typically moves at least 5-7% post earnings and Cisco at least 4-5%. One could construct a trade which would make around 40-50% if the stock makes a "typical" move. An example of such a trade would be a Reverse Iron Condor. However, if the stock moves less than expected, the trade would lose up to 100%. In the case of Google, the trade would make a maximum gain in 8 out of 10 last cycles. In the remaining two cycles (April 2012 and January 2011) the trade would lose 100%. For Cisco, 7 out of 10 last cycles would gain ~40-50%, and the rest might lose up to 100%.

In comparison, we could construct a trade to be opened few days before earnings and closed just before the earnings, to take advantage of the rising IV. It would produce an average gain of 15% in the last few cycles. It is very rare for those trades to lose more than 7-10%. You can see the full 2012 performance here. As always, slow and steady wins the race.

You can see here how to trade the Cisco next week's earnings using this strategy.

So what is better -- to have eight 50% winners and two 100% losers or to have ten 15% winners?

In the first case, your accumulative return is 200%. In the second case, it is "only" 150%. But here is the catch that many traders ignore: those returns don't account for position sizing. The second trade is much safer, so we can allocate a much larger position to those trades. The first trade should be handled as a speculative trade, where you should assume a 100% loss upfront. Allocating more than 2-3% of your account to such a trade is playing with fire, as proven by the latest Google and Cisco earnings.

Now do you see the difference? With the second trade I can have smaller average returns, but with proper allocation, I'm still way ahead. Do you still think that 50% is always better than 15%?

The biggest problem with the first trade is the false sense of safety it provides. Some people present those trades over and over again as the safest way to play earnings. Nothing could be far from the truth. Those are speculative trades which should be handled with great respect. Otherwise, the risk of devastating loss is real. The correct definition of those trades is a "high risk, high reward, high probability" trade. However, the high probability should not be confused with low risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.