Why are We Receiving a Higher Return When We’re Expecting a Lower Return? – July 18, 2022
On 2/21/2022, Frank emailed me about our 10-Delta ultra-low-risk cash-secured put strategy. With Moderna Inc. (MRNA) trading at $145.00 per-share, he asked about using the deep out-of-the-money $118.00 weekly strike that expired on 2/25/2022. Let’s evaluate this trade to see if it aligns with our strategy goals and personal risk-tolerance.
MRNA option-chain on 2/21/2022
The 10-Delta requirement is met by the $118.00 strike (-0.992) and shows a bid-ask spread of $1.23 – $1.53. This is definitely a negotiable price but, for purposes of this article, we will use worst case scenario of $1.23 (published bid price).
Factor #1: Expectations of lower returns than normal: Monday is President’s Day creating a 4-day week
Let’s feed the option-chain data into the BCI Trade Management Calculator (TMC) to see if the initial returns meet our stated goals (let’s say 0.5% per-week, 26% annualized as a reasonable hypothetical):
The spreadsheet shows a 4-day return of 1.05%, 96.12% annualized (red arrows) with a breakeven price point of $116.77. If the option is exercised, MRNA would be purchased at a 19.47% discount from the price when the trade was initiated (blue arrow). This is certainly not lower-than-expected returns but, in fact, much higher. What is causing this skew in expected returns? Why is the implied volatility of MRNA so high this particular week?
You guessed it …earnings will be announced this week
Discussion
When selecting strikes for our 10-Delta ultra-low-risk put strategy, in addition to the 10-Delta requirement, we must also ensure the time-value returns meet our previously stated goal range. When the return is surprisingly high, we must check what event is causing this rise in expected implied volatility. In a majority of these instances, the cause is an upcoming earnings release and the trade should be avoided until after the report passes.
Author: Alan Ellman