I'm not being melodramatic when I say that I get email almost daily that breaks my heart.Here's an example of the correspondence I receive from burned options traders. Admittedly, most of the stories of loss reported by readers are not of this magnitude in raw dollars, but from a percentage of portfolio standpoint, I bet they're all pretty close. I made a little money on AAPL calls over the past 3-4 months
At $32.20, seven contracts ran $22,540. Based on the email, I assume he purchased that many. When AAPL peaked, he was sitting on roughly a 27.5% profit. Of course, given the hysteria surrounding AAPL at the time, he did not take that profit. Emotion, in one form or another, took over. The stock dipped and the bulls on television and messages boards helped strengthen his resolve. And they were correct. Apple crushed earnings estimates. In all of their spot-on predictions, however, they were not considering the situation of a person sitting on massive losses heading into the report and facing somewhat subdued, but still pretty considerable losses afterwards as two factors took hold: ¿ Implied volatility tanked after earnings, sucking the life of the option premium; and ¿ AAPL did not retouch its early- to mid-April highs. In fact, it did not even come close. On the day of earnings, that 27.5% gain had turned into an 81.2% on-paper loss. The day after earnings, it recovered to a roughly 59% loss, only to swoon again thanks to dual impacts of implied volatility and time decay. This experience teaches the lesson to turn off the television, stop reading articles and comments from cheerleaders on sites like MacWorld and take a freaking 27.5% profit when you're lucky enough to have one. But, more than that, the emailer entered a trade that's risky no matter what your level of experience, but particularly risky to somebody who had been using options for just a few months. Everybody is a winner when they're buying calls on a parabolic stock in a bull market. It gets tricky when the stock starts to gyrate in both directions, earnings draw near and the time to expiration on your option contract gets frighteningly close. While he would not be in great shape, consider the better alternative had the reader opted for the AAPL January 2013 $550 call on April 4.
From high to low, he would be looking at an on-paper loss of 38.2%. The day after earnings his loss reduced to around 9%-10% -- much more manageable. Several reasons exist why you're better in-the-money and in options contracts with a minimum of four to six months to expiration. Two major concepts come into play here -- intrinsic value and time decay. I cover them extensively in my newsletter and will discuss them further in follow-ups to this article in the coming weeks on TheStreet.