Update January 2021
Please, check your risk exposure, when taking advantage of elevated option premia in parabolic movers. Margin requirements on naked short calls can skyrocket very quickly and risk is uncapped.
While the probability of a significant loss at the end of the trade is low, the loss size can be devastating and the path extremely rocky.
A call spread (and put spread) limits that risk and is a more prudent way to implement the strategy below: sell a call near the money and buy a call further out of the money with the same expiration date.
There is nothing like a story of extraordinary gains to play havoc with investor psychology. Especially when it is founded on asset price moves of a magnitude that could mean life changing levels of profit – if you had only participated in it.
Such parabolic irrational exuberances, that drive prices and valuations to unsustainable extremes, happen all the time. And when they are really extraordinary, they are hard to miss as every financial news outlet screams them at you – as in the recent examples of cryptocurrencies or cannabis stocks.
In this post I want to explore some possibilities to take advantage of such moves profitably using a repeatable process with a sustainable edge. I will concentrate on parabolic moves to the upside, but the same ideas should hold for extreme breakdowns.
Parabolic moves are impossible to predict…
First of all, as I don’t play the game of prediction, I rule out the possibility of actually systematically identifying these opportunities in advance and participating in the parabolic move before it becomes obvious. I want all of my trading approaches to be systematic and repeatable, and will wait for such moves to occur so that it is easy to screen for them or until they are blatantly obvious in mainstream financial media.
We want these moves to be as extreme as possible to form the basis for this trading idea.
Of course once we see the opportunity, the parabolic move has already happened and all we are left with to base our idea on are hyped-up investor emotions. Let’s analyze the likely behavioral outcome of such strong emotions of FOMO, greed and panic – maybe there is a high probability setup to use the repeated mistakes highly emotional investors make to our advantage.
…and hard to time
The pattern of a parabolic move peaking into a strong retracement or consolidation is repeated quite reliably over and over again. Trees simply don’t grow into the sky.
The huge obstacle is exact timing: how long the parabolic move can last depends on how far the hype spreads – crazy valuations can become truly insane when everyone starts to pile in.
But here is where I see the genesis of a trading edge: whenever the news flow becomes really extreme and the same subject (eg. cannabis) or even individual names (eg. Tilray TLRY) take center stage virtually everywhere you look, an opportunity arises.
I have several general financial news sites, investment blogs and podcasts I consume regularly and whenever they all comment on something spectacular around the same time – the game is on. It implies, that everyone with a speculative mind set has gotten interested and starts driving the parabolic move that initially had few participants, but rapidly starts growing in breadth – an obscure idea becomes mainstream and prices, that lack any common sense, are being paid.
Stages of investor reaction
Depending on experience and level of reflection investors react differently to such a speculative opportunity and we want to have many novice speculators (with strong behavioral biases) driving prices to irrational levels to give us a strong edge.
These are the main reactions to a spectacular price move by different groups of speculators:
- Extrapolation of parabolic growth going on forever. FOMO (fear of missing out) causes unexperienced traders to flood into the market. This irresistible urge to go long drives the parabolic move, but history shows this to be a trade with a high probability for massive losses – when the opportunity has become obvious to the unexperienced it is usually dangerously late in the game.
- Many traders will try to utilize call options to participate on the long side – either because they have little capital and are purely driven by greed or they are a bit more thoughtful and aim to constrain their maximum risk. In any case option demand on the call side is high which can cause options to get relatively expensive compared to the underlying asset´s historical volatility.
- Anticipating mean reversion: knowledge of the impossibility that prices go up forever make this an enticing second level (but by no means uncommon) trading idea: fade the unsustainable move back to more rational levels.There are three basic ways to implement this:
- Short the stock – which brings several issues with it, that often make the short irrationally expensive and risky: an unconstrained loss profile paired with limited potential gains; the necessity of having shares available to borrow; high lending fees, especially when the chance is extraordinarily good and obvious (during Tilray´s September 2018 move these got up to 400% annually; across all cannabis stocks one pays a fee of about 19% currently)…
- Buy put options: losses are constrained, but high demand makes them very expensive resulting in a low probability of being able to profit from the option.
- Short call options: at first this sounds bad: we have an unconstrained loss profile and profits are capped at the premium received for the option. But when we look closer, we see, that the high demand actually makes this a high probability play: Overpriced options will expire worthless when the stock consolidates or falls – with a large margin of safety. Every day of falling volatility and sinking demand will put money in the sellers pocket even if the stock price stays unchanged.
- Short strangle: the picture looks even better, if we combine a short put with the short call above creating a strangle that takes advantage of overpriced options on both sides (and creates a hedge). Let’s look for indications, that tell us that option prices really got out of hand and are unlikely to get much more overpriced.
A distinct edge lies in the fact that options get extremely overpriced due to abnormally high volatility and sky-rocketing demand.
A practical example: Tilray case study
Huge option demand causes investors to overpay massively – this gives the option seller a strong edge. Extraordinary premia are quite rare and are caused by hyped up stories, when mainstream demand and volatility coincide.
During Tilray´s parabolic September move we saw option premia skyrocket to around 20% for very far out of the money options: 30% (put) to 60% (call) out of the money strikes (common premia, even for high beta stocks, would normally yield 1% to 3% far OTM). This gives an option seller a large margin of safety against adverse price moves. For a profitable trade a strangle would only need to stay within the range between the strikes plus the premia received by the expiration date. In practice price fluctuations can be used to take profits before expiration and tilt probabilities further in our favor.
Data from real trades I took to test the idea in practice:
September 20th, 2018 with Tilray @ $210. Stock was down in early trading, after being all over the news with an extremely volatile day on the 19th: High: $300; Low: $151,40 – a span of 100%. It had gained over 700% since its recent IPO.
I sold a strangle with strikes well outside of the huge range of the previous day for a premium of about 2x 20% of the value of the underlying stock at the time of the sale:
- TLRY Jan18’19 350 CALL @ $40
- TLRY Oct26’18 140 PUT @ $42 – the expiration for the put is only one month out as I thought it was unlikely, that the hyped-up price for the stock would be sustainable much longer.
Hypothetically these option premia mean that the strangle will yield a profit, if the stock price at expiration stays within the immense price range of strike plus/minus both premia: $58 – $432! Only beyond that range would I even start to post my first $ of loss – that’s a huge margin of safety.
In the case of the put, for example, this means that I get to buy Tilray for $58 (pay $140 – premia received $82), if it stands below $140 on Oct. 26th – sounds like a great deal to me: a 73% discount on today’s price.
The loss scenario seems highly unlikely, especially because I manage the trade in the time before expiration and use price fluctuations to roll options positions forward and/or add a second position according to some rules that I put together on the fly to test out my idea (see below).
Tilray trade sequence
This is the resulting timeline of the trade up to Oct. 9th:
Sept. 20th: the stock dropped like a stone for 3 days until Sept. 24th
- sold TLRY Jan18’19 350 CALL @ $40
- sold TLRY Oct26’18 140 PUT @ $42
- closed TLRY Jan18’19 350 CALL @ $19,5 for an intraday profit of 51%
Sept. 24th: the stock hit a low of $97,12 then bounced back hard to a high of $173,64 on Oct. 1st
- sold TLRY Dec21’18 190 CALL @ $14
- sold TLRY Dec21’18 72.5 PUT @ $20: two open put positions against one call
Sept. 28th: Tilray @ $140
- sold TLRY Jan18’19 200 CALL @ 20
- closed TLRY Dec21’18 72.5 PUT @ $9 for a profit of 54%
Oct. 1st: Tilray @ $170
- closed TLRY Oct26’18 140 PUT @ $20,4 for a profit of 51%
Oct. 8th: Tilray @ $138
- closed TLRY Jan18’19 200 CALL @ $10,4 for a profit of 47%
Oct. 10th: Tilray @ $130
- closed the last position TLRY Dec21’18 190 CALL $9,9 for a profit of 28% – despite a rise in the stock of about 30% over the holding period! This shows just how overpriced the option was even on Sept. 24th – falling volatility and demand more than compensated for a move of the stock against the position.
- New option positions would still yield relatively high premia, but the margin of safety is now less than half as big as it was initially – fresh news and a new price burst in the stock could cause option premia to rise dramatically – the trade has become much riskier.
Overall this real example trade worked perfectly (about 46% average profit on all closed positions – using conservative position sizing!) despite massive price swings. But it could also work out differently, if prices move strongly in one direction.
Backtests* for this idea are hard to do, because accurate option data around the time of parabolic moves is hard to get. I rely on my experience and viability studies for a general short options strategy
, that I have been running live for three years: I see this event driven strategy as a way to further tilt probabilities in my favor using a basic strategy that has shown to have a long term edge (the volatility risk premium) in its most basic form. It yields higher premia and, because these premia are demand driven, they come down very quickly once the hype is getting old – leading to quick profits.
Amarin case study
A second example shows how the strategy can go against you for some time, if the timing is wrong and option demand is still growing:
I screened for other parabolic moves using FINVIZ to filter stocks that jumped 30% in one week or 50% in a month and found a handful of stocks:
- Another Cannabis play NBEV with a similar overpriced level of option premia as TLRY.
- Biotech stock Amarin Corporation plc (AMRN) which showed an overnight jump of over 300% on positive news on Sept. 24th.
Amarin wasn’t headlined in the mainstream financial media and, despite the extremely volatile price jump, showed much lower option premia than our TLRY example:
- 14% premia for far out of the money options (15% out of the money strikes) give only half the margin of safety against adverse price moves.
During the two weeks after the price jump prices continued to steadily double again within 8 days and interest in the stock and its options continued to grow. This led to an adverse move in a hypothetical short strangle: while premia for a put sold on Sept. 25th hardly moved, despite the large beneficial price move in the stock (due to rising option demand), call premia quadrupled simultaneously resulting in large book losses 8 days into the trade.
But at the same time the opportunity became much better: In this case I would opt to add another call position rather than use a stop loss (against common trading wisdom) and close both positions at a smaller profit once demand fell and mean reversion kicks in.
Demanding higher premia to put on the trade in the first place would be even better – this would result in a lower number of opportunities, but much higher win probabilities.
From these two case studies (combined with the results of hundreds of previous option trades) I came up with the following rules to have a systematic framework albeit with a lot of discretionary judgment thrown in. I feel quite comfortable adding positions on adverse moves, because I keep position sizes small: premia received amount to 0,5% of capital for each position; 1% NAV for the strangle.
- Extreme mainstream attention: stories about the asset´s move are everywhere
- Stock screen for parabolic move in FINVIZ: +50% in one month; +30% in one week
- Very high volume
- Very high option premia of around 15% to 20% for far out of the money options
- Option strikes 20%-40% (put) and 50%-70% (call) out of the money give a large margin of safety against adverse price moves
- If these criteria are met sell strangle at any time
- Be prepared to add a second position on either side during price fluctuations
- Close positions at 50%-60% profit target
- Roll into new positions if the opportunity is still good – again using price fluctuations for advantageous prices
- No Stop Loss – close position a day before expiration, if profit target is missed
From previous experience I would estimate a win probability well above 80% and an average loss of 2-3 times the average profit, which should make this a nicely profitable extension of my overall short option portfolio.
*In his recent book “Buy the Fear, Sell the Greed – chapter CRASH“, Larry Connors quantifies and backtests a similar strategy for shorting parabolic moves outright. He filters stocks by high volume and high volatility and shorts them on extremely overbought readings of the RSI indicator (rather than using the size of option premia to identify extremes). His results come in at a 72% win probability with average win equal to average loss – in my opinion missing out on the additional volatility risk premium inherent in option selling.
He gives a case study on Overstock.com, Inc. – an example from the cryptocurrency mania – in the book.