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Respect for Risk

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BY: HANS ALBRECHT, CIM®, FCSI®, VICE-PRESIDENT, PORTFOLIO MANAGER AND OPTIONS STRATEGIST, HORIZONS ETFS

May 11, 2017

Those who trade options are often in one of two camps. In one, there are a handful of thrill-seekers who love using the inherent leverage in long options to capitalize on a potential move. In the other, there’s the majority – those who love shorting options and kicking back while the theta decay trickles in over time.

Sure, it always feels great to nail it and have a short option expire worthless, but until then, there is always risk of movement. For an option buyer, movement is beneficial. For an option seller, movement is the enemy. Once you’ve sold your options, you generally want the market to do nothing until expiry.

When earnings season is upon us, we often see option pricing inflate as participants worry about the potential for stocks to fluctuate when earnings reports are released. Is that a great time to be selling calls into that juicy spike in option pricing? No.

The possibility of opening-morning gaps becomes very real. We want to always recognize that realized movement is our enemy and that it’s actually better to sell at a slightly lower price than to sell options into market moving events. Think of earnings plays as binary – the news usually comes out after the market close or before the market open. Sometimes the options underprice the eventual move, but Goldman Sachs has found that the average stock rises on earnings, outpacing the market’s expected upside move in near-term calls. “The strategy of buying calls across the board has produced an average profit of 14% and was profitable in each of the last 19 years studied.”1 In other words, despite the earnings premium commanded in the calls, the market is getting the pricing wrong based on the tendency for stocks to rise higher than expected following earnings.

More specifically, this has worked early in the earnings cycle as the ‘surprise’ factor worked better. On the first 13% of the S&P 500® Index earnings reporting, they saw a return of 105% from on the money short-term call buys. Now of course there is no guarantee that any one stock, or indeed any stocks, will go up at all. But shorting options into earnings or other big potentially market moving events? No thanks. Know where the risk lies and respect it.

1 Source: The Goldman strategy that’s returned 105% in days, www.CNBC.com, April 22, 2016.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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