vibey vs discrete trades

At the Robinhood Summit last week, Mat Cashman and I hosted a “Trading Lab” emphasizing that options are surgical tools. You only want to reach for them when you have a specific view. While their payoff is highly levered to nailing a particular timing, they are unforgiving to vague forecasts like “I generally want to be long this stock”. If you buy the stock instead, you know your exposure. Your delta is 1.00 and doesn’t change.

If you buy an option, your exposure changes due to time passing alone. So that initial decision thrusts you into a series of future decisions, each one challenging you to tighten your thesis and face yet another bid/ask spread.

To demonstrate an appropriate use of options we stepped through a highly specific example during the lab and even executed the trade live!

I’m going to walk you through it here today.

Setup

The session was on Wednesday, September 30th. Nike (NKE) reports earnings after the close Thursday, October 1st.

Some context:

✔️NKE is down ~75% since its lifetime peak which occurred 5 years ago. While falling short of the peak, it did stage a large rally from late 2022 into 2023, before resuming its downward March which accelerated this year with the stock down >40% YTD at the time of the session.

✔️NKE typically pays about $1.40/yr in dividends or greater than 4% yield at recent stock prices. However, it can no longer fund the dividend from current cash flows. They could fund it from balance sheet assets (ie dip into their savings) to be able to pay it for several more years. I learned this from Brett Caughran’s tweet:

✔️I used moontower.ai’s MCP (which is now included with individual plans 😉) to ask Claude if the options market was anticipating a cut. It turns out the implied dividend about 1 year out is 50% of what NKE has been paying. NKE’s woes are out in the open, the stock and options markets see them.

With such a backdrop, we expect this to be an important earnings call. After all, if a plane is nosediving, we expect the captain to say something. (We know the content of the words will be reassuring, but we’ll listen to the tone of his voice to infer how scared or optimistic we should be.)

Pulling up the option chain

With the above context in mind, we load the October 2nd option chain. This is clean as a market gets around an earnings move since the options expire 24 hours after the earnings call.

During the session, I reason aloud through what I’m looking at.

The stock is ~$36. The 36 straddle, which can be interpreted as the average expected move size, is ~$3 or 8% of the stock price. Earnings are a big deal.

I gracefully elide the question of whether you should be bullish or bearish. If I was privy to such information, I’d be a Market Wizard. But many people have views and wanna bet. I can help you reason through your choices given you have a view. So let’s get specific.

What are you paying for?

We arbitrarily side with the bulls, but the analysis that follows works for bears as well if they substitute different contracts.

If the 36 straddle is at-the-money, meaning the stock is also $36, then the 36 call is half the straddle or $1.50.

If the stock experiences the expected move to the upside those calls will double your money as they will be worth $3 of intrinsic value at expiry. In the language of odds, you get paid 1-1 on an 8% up move.

But if this is our specific bet, can we find an expression of the trade with more octane?

We load up the 38.5/39 call spread. It’s marked for $.12 and if NKE expires $39 or higher, it will be worth $.50.

You risk $.12 to make $.38 so you are getting just over 3-1 odds for the same $39 outcome.

Why does this sound so much better than getting 1-1 if we just buy the 36 call for $1.50?

Because the outright call continues to pay off if the stock climbs more than 8%. You are paying for the extra profit potential if NKE goes up 10, 15, 20 percent. Being vague leads you to pay for more margin of error. But if you’re specific, you can get extra leverage on being right. Of course, this is risky because if you’re wrong most scenarios lead to total loss.

Let’s deal with the risk

The setup of the session was that we have $5,000 of capital.

If we are wrong on the vertical spread and the stock doesn’t clear $39 then we likely lose our entire premium.

We get a 3-to-1 payoff when we are right.

This type of binary outcome is a perfect setup to use Kelly sizing. The nice thingabout Kelly is that it assumes you have a total loss when you are wrong, so the sizing itself is the risk management. You’ve already budgeted for the maximum risk.

We’ll get to the sizing in a second but just for building fluency in thinking probabilistically, let’s acknowledge a few heuristics:

1. We know from the derivation of the straddle approximation, that the straddle is 80% of 1 standard deviation. Therefore, it encompasses ~79% of the distribution assuming normality. Therefore the upper tail, where NKE goes up more than $3, is expected 21% of the time. To get 3-1 odds would require a minimum probability of 25% to be a positive EV bet. But, normality is doing a lot of lifting in that sentence. Earnings are more likely a binary outcome, and while it’s too simplistic to say there’s a 50/50 chance of the stock going up or down 8% (which would make this vertical spread seem irresistibly cheap), it’s not unreasonable to think the probability of that spread hitting is greater than 25% (or for that matter, for the symmetrical downside put spread for those with a bearish view).

In the name of walking you through sizing GIVEN you already have the bull view, we’ll presume you believe there’s a 40% chance the stock pops higher by the amount of the straddle or $3 to $39.

How much should we bet on the vertical spread if we are getting 3-1?

Kelly:

Plug and chug:

f* = .40 – .60/3 = 20% or $1,000 of the allotted capital

Converting to contracts:

Each option contract is $.12 or $12 once we adjust for the 100 share multipler.

$1,000/$12 ~ 83 contracts

We don’t want to risk overbetting if we overestimate our p (i.e., probability of winning), so let’s size to about half Kelly and only buy 40 contracts.

We actually bought the vertical spreads live during the session.

Postscript

NKE ended up falling after earnings. The equivalent put spread on the downside would have been the 33.50/33 put spread, looking to get paid if NKE fell $3.

NKE closed Friday at $33.90, so the put spread would have expired worthless. At one point, the stock touched $32.09, so the spread would have been deep in-the-money, but because there was still some time value remaining, you wouldn’t have been able to capture its maximum value, although you probably could have flipped out of it and tripled your money, from $.12 to $.36

But it would have been hard to do since, with the stock sitting around $32 you have theta on your side, and you’d probably be thinking, “even if the stock rallies $1 or 3% intraday, I’ll have turned my $.12 into $.50.”

Alas, the stock ripped 6% intraday after bottoming, leaving the put spread worthless!

Notice how tricky this is for everyone. If you were short the spreads, you ended up collecting the full $.12 of premium, but the path would have greyed your hair as it looked like you’d face maximum loss or feel forced to cover only to later watch NKE stage a heroic rally.

Closing words

Options are surgical. I think of them like term life insurance. I have a specific thing I’m trying to mitigate or take advantage. If I buy them and lose, it may or may not have been a good outcome depending on what the counterfactual would have been. The term life analogy is an obvious demonstration of benchmarking to the right outcome.

The more tightly you can wrap an option expression around a terminal value thesis, the easier the risk management is because you can budget for total loss and let sizing do the heavy work.

Thinking probabilistically is a habit of mind. Reasoning between what’s in a price and your own confidence intervals around scenarios will develop not just discipline but it gives you metrics, even if they are finger-in-the-air estimates, to journal or track, allowing you to get a bit more calibrated with each rep.