How To Implement Cheap Black Swan Protection

The following is a guest post from Kim Klaiman, full time options trader and founder of


The earnings season provides a lot of opportunities for active options traders. Some traders like to play earnings with directional bets, buying straight calls or puts. This is a very tough strategy. You have too many factors playing against you. Even if you are correct about direction, you need to overcome the Implied Volatility (IV) collapse that usually comes after earnings are announced.

Others play it with non directional strategies like straddles or calendars, but hold the trades through earnings. Those strategies can definitely work, but they could also be very volatile due to unpredictability of earnings.

Personally, I prefer to play earnings non-directionally. One of my favorite strategies is buying a straddle a few days before earnings and closing the position before the announcement to reduce the risk.

How straddles make or lose money

A straddle is a vega positive, gamma positive and theta negative trade. What does it mean?

  1. The theta is your enemy: all other factors equal, the trade will be losing value due to time decay.
  2. The vega is your friend: increase in IV (Implied Volatility) will help the trade.
  3. The gamma is your friend as well: stock movement in any direction will help the trade.

The straddle makes money as follows: The stock has to move (no matter which direction) and/or the IV (Implied Volatility) has to increase.

A straddle works based on the premise that both call and put options have unlimited profit potential but limited loss.

While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises or falls, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be closed before expiration for a profit.

You execute a straddle trade by simultaneously buying the call and the put. You can leg in by buying calls and puts separately, but it will expose you to directional risk. For example, if both calls and puts are worth $5, you can buy a straddle for $10. If you buy the call first, you become bullish — if the stock moves down, the calls you own will decrease in value, but the puts will be more expensive to buy.

This is how the P/L chart looks like for a straddle:

When to use a straddle

Straddles are a good strategy to pursue if you believe that a stock’s price will move significantly, but unsure as to which direction. Another case is if you believe that IV of the options will increase — for example, before a significant event like earnings. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our model portfolio for consistent gains.

Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work in some cases, I don’t do it. The reason is that over time the options tend to overprice the potential post earnings move. Those options experience a huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move. This is the reason why we will always close those trades before earnings for whatever P/L we can get. There will be some rare exceptions, but in general, this is the rule.

How straddles can serve as a cheap black swan protection

I like to trade pre-earnings straddles/strangles for several reasons. There are three possible scenarios:

  1. The IV increase is not enough to offset the negative theta and the stock doesn’t move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.
  2. The IV increase offsets the negative theta and the stock doesn’t move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
  3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring a few very significant winners. For example, when Google moved 7% in the first few days of July 2011, a strangle produced a 178% gain. In the same cycle, Apple’s 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had a Disney strangle and a few other trades more than double.

During broad market corrections, you can have very nice gains, as a result of both stock movement and IV increase. So the losses are usually very small, the winning percentage is around 70%+ and you get cheap black swan protection.

Here is just one example using the August 2011 meltdown.

Walt Disney (DIS) was scheduled to report earnings on August 9, 2011. With the stock trading at 37.30, you could buy a 38/36 strangle with expiration at August 19, 2011, ten days after earnings.

The P/L chart would look like this:

Fast forward to the next Monday, August 8, 2011:

That’s right, after the market was down double digits, the strangle value almost tripled.

Of course those huge gains are not common. You need a severe market correction to get them. But for a strategy that produces stable 7-10% gains with very low risk, having this black swan protection in the portfolio is a huge added value.

Profit Target and Stop Loss

My typical profit target on straddles is 10-15%. I might increase it in more volatile markets. I usually don’t set a stop loss on a straddle. The reason is that the upcoming earnings will usually set a floor under the price of the straddle. Typically those trade don’t lose more than 5-10%.

The biggest risk of those trades is pre-announcement. If a company pre-announces earnings before the planned date, the IV of the options will collapse and the straddle can be a big loser. However, pre-announcement usually means that the results will be not as expected, which in most cases causes the stock to move. So most of the time, the loss will not be too high, especially if there is still more than two weeks to expiration. But this is a risk that needs to be considered.


Earnings straddles can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without the need to guess the stock direction.

Kim Klaiman is a full time Options Trader and founder of – options education and trade ideas, earnings trades and non-directional options strategies. Read more from Kim on his Options Trading Blog.



Diary Of A Professional Commodity Trader

A Review Of Peter Brandt’s “Diary Of A Professional Commodity Trader”

It’s a rare opportunity to get an inside look at the trading process of a legend. But that’s exactly what Peter L. Brandt (PLB) provides with his book Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading. Read more

risk management

What We Can Learn From The Masters

Everytime I watch golf I can’t help but think of how many similarities there are between successful investing and championship level performance on the golf course.

Anyone who’s attempted a round of 18 holes knows how difficult golf can be. The game is a ruthless fight between you and the course. You’re constantly engaged in an uphill battle. It’s uphill because with each hole you have the limited potential to shoot a few under par, but the unlimited risk of shooting way over.

Take a par 3 for example, the best you can do is shoot a hole-in-one. And that rarely happens even for professionals. Yet the worst that can happen is devastating. You could shoot 3 over, 4 over, 5 over, or even 6 over par on that short little par 3. This is what we call negatively skewed risk to reward. We can only shoot under par by so much, but we can shoot over par by an unlimited amount. Poor Jordan Spieth quadruple bogeyed the 12th hole at the Masters this weekend and went on to lose the tournament because of it. He had been in the lead the entire time only to lose in the final few holes.  Read more


Bill Ackman Could Learn A Thing Or Two From Technicians

Taking concentrated fundamental bets is no different than playing craps in Vegas.

By now you’ve heard about Bill Ackman and his white whale — Valeant Pharmaceuticals (VRX). In 2015, Valeant plummeted and Ackman’s fund was down 20.5%. His misfortune continued into 2016, with his fund losing another 26% year-to-date after Valeant’s latest drop. Valeant’s share price was cut in half that day, and the troubled manager lost a cool billion on his position. Talk about a bad day at the office…

A billionaire like Ackman could really use a lesson in risk control from a market technician. His hubris and ego has literally cost him billions. He’s failed to execute the most important rule to successful investing and trading — cutting losses. You would think he learned something from his first rodeo when he went “all in” on a failing company. Ackman’s first hedge fund, Gotham Partners, doubled down on a bad bet and blew up as well. But remarkably, he was able to convince more people to come ride the pain train again in his new fund — Pershing Square.

The importance of risk management and trade management in the market cannot be overstated. That’s why at Macro Ops we use both fundamentals and technicals in our process. Stock picking and conviction is not enough to succeed in this game.

In pure fundamental investing, it’s believed that the lower the price (all else equal), the more attractive the trade. This is because price is further away from the investor’s best guess (and yes it’s nothing more than a guess) of “fair value”.

This is not the case in technical investing. Technicians approach the market in the opposite fashion. They would tell you that price below your cost is a signal to exit. You’re wrong and receiving negative feedback from the market. The attractiveness of the trade decreases as the price moves against you.

We side with the technicians on this one.

Arrogant fundamentalists like Ackman never admit defeat and never cut losses. Instead, they buy more because they believe they’re buying at a “better” price.

At the beginning of 2016, Ackman doubled down and bought more Valeant shares despite piss poor performance in 2015. That’s called doubling down on stupid…

Valeant just continued to fall lower after his purchase. As you can see below, from it’s high, Valeant has lost over 87% of its value.


This approach of averaging down and holding onto losing bets is nothing more than gambling. Investing icons such as Ackman like to make big calls. If they’re right, assets under management swell. If they’re wrong… the fund blows out. Which is exactly what happened with Ackman’s first fund, Gotham Partners.

This approach to markets has zero risk control. It’s the “pennies in front of a steamroller” trade in different form.

No one can continuously outsmart the market, even with a Harvard MBA. If you don’t cut your losses the market will do it for you with a margin call. And to make matters worse, your precious investors will redeem their assets once they see a big loss on their statements.

This may come as a shocker, but the most important thing in trading has little to do with whether you find an undervalued stock that rises in price.

Don’t take this the wrong way, trade selection has value, but it’s vastly subordinate to the path the underlying investment takes after you enter it, including how you manage that path. In other words, trade and risk management are a priority over everything else.

A lot of people get confused when we talk about the “path of the underlying”, but the concept is simple.

Take a look at the chart below:


The three lines represent three different “paths” that could play out after you buy a stock. The blue line trends straight to the target with little drawdown. The yellow line gives you a lot of heat, but eventually comes back and hits your target. And the purple line rewards you right off the bat, but then takes a turn for the worse. The purple line is Ackman’s Valeant.

It’s impossible to predict this path with any amount of accuracy. You can try, but attempting to do so is akin to guessing what next Saturday’s Powerball numbers will be.

You have 0 control over whether people will buy your stock after you.

You have 0 control over what management will do in a company you don’t even operate.

You have 0 control over what the stock price does at all.

But you DO have control over when you decide to hop on or off the path.

At the end of the day, what shows up on your account statements are your entries and exits. Not your 80 page thesis that you touted to your Ivy League colleagues. The cold hard profits and losses created by your buying and selling is the only thing that matters.

Take any of your favorite performance metrics: sharpe ratio, gain-to-pain ratio, sortino ratio, and calmar ratio. They all look at your equity curve, not your research. Your equity curve is what graphs your trading account’s performance. So ultimately, how you manage risk is what moves these numbers up or down. Your returns over your drawdowns is what matters the most, not whether you ended up being right on a thesis. This is why trade and risk management are far more important than investment selection for longevity and performance in the markets.

To better explain this concept, let’s go back to the path diagram:


Pictured are three different scenarios, all of which you were “right” at some point during the trade.

Scenario one is the blue line. The blue line is the easiest path to stomach. It has little drawdown and slowly trends upward towards your valuation target. In raging bull markets, like we had since 2009, a lot of hotshot investors saw their picks trade in this fashion. They touted their “genius” and “insight”, which the investing public bought into, causing those managers’ AUM to soar.

Scenario two is the yellow line. This is where things become tougher. Yes, your target was eventually hit, but look at the drawdown you had to suffer through to get there. Could you realistically stomach paper losses for the first year or so you were in the trade? How much doubt would you have? Also, holding this will put a dent in your performance metrics. Holding onto any type of drawdown will.

Guys like Ackman will typically hold the yellow line or even double down on the yellow line.

This may work great for a while, until a purple line pops into your life… which can happen even if you’re a seasoned billionaire.

Scenario three is the purple line — the most painful of them all. You bought the stock, and were immediately rewarded. But it didn’t quite hit your valuation target. You were hoping for more from your little darling. Then, unforeseen information comes out and the stock starts to take a turn for the worse. But the initial run up made you confident that the stock is a good company and that it’ll “come back.” Yet as time passes, the stock drops, and you become more and more wrong. The anxiety and pain is now at level 11 out of 10. You aren’t sleeping at night. You’re pulling your hair out and questioning whether you had any investing skill in the first place.

The problem is you never exit and control risk because you believe in your own story over the market. The purple path is what finally blows out the arrogant who refuse to respect price. Holding onto a purple path is a career ender. It involves PERMANENT capital loss. And permanent loss in equities happens a lot more than you would think. You just never hear about the losers.

Technicians wouldn’t stay on the purple path. They would react to the adverse price action and protect their profits. Or at least exit that trade for a small loss.

If stocks were illiquid like private investments, you would be stuck on the “path” and all the anxiety and negative emotions that come with it. But lucky for us, they aren’t! You don’t need to suffer through a purple path if you have appropriate trade and risk management.

Fundamentalists can take a page from the technician’s handbook and have their entry and exit rules determined before they enter a trade. With rules in place, you can recover when you’re wrong and limit your account drawdowns to something that’s not career ending.

If you don’t control the path, the path will control you.