You Can Lose It All With Apple Options

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 total time i have been trading options On 4th April I purchased 10 $620 May19 call totalling $32,500 approx since then the stock has tanked with losses ammounting to $23,000. Unfort i also paid 7 puts around earning instead of a straddle and lost $11,000 before i exited the trade the day after earnings. All the money i made on profits from aapl have been washed off and i was hoping how and when i can exit the May19th call with as little a loss as possible.

I would say 75% of the queries I receive about salvaging sizeable losses involve Apple. At first glance, that seems a bit odd considering the fact that AAPL has been such a hot stock. It just goes to show that options, even on parabolic stocks, can be sucker bets when used improperly.

I publish a weekly Options Investing Newsletter with fellow TheStreet contributor Robert Weinstein to provide the most basic options information to investors. I tend to stress two rules repeatedly in the newsletter as well as in the articles I write. When going long an option contract:

¿ Give yourself a minimum of four to six months' time to expiration.

¿ Favor at-the-money and in-the-money (preferably deep ITM contracts), over out-of-the-money (particularly deep OTM contracts).

Other than carefully considered covered calls and very carefully considered cash-secured puts, this is the only strategy new options investors should use -- long-dated, ATM or ITM, preferably deep ITM, long calls and puts.

By adhering to this philosophy, you effectively take much of the confusion out of options. You remove, at least for a considerable duration, common obstacles such as time decay. An important corollary to the aforementioned two points, do not initiate these long positions ahead of major events such as earnings. This helps mitigate the potential negative impact of implied volatility. If you do anything with options into earnings, you should be selling them, but that's another story for another article.

The reader quoted in this article got into his AAPL May $620 calls on a day when the stock ranged between $617 and $625.86. To be fair, he did not make a completely crazy trade. Unfortunately for him, however, he did not flip those calls when AAPL reached highs between $636.26 and $644. That would have been the prudent thing to do. Consider the chart on that call from the time he bought it until Friday's close, courtesy of BigCharts.com:

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.

More from Options

Here's a Better Way to Hedge Using Stock Options

Here's a Better Way to Hedge Using Stock Options

Let the Najarian Brothers Crash-Proof Your Portfolio

Let the Najarian Brothers Crash-Proof Your Portfolio

Let the Najarian Brothers Help You Generate Income With Options

Let the Najarian Brothers Help You Generate Income With Options

Learn Options Trading from the Najarian Brothers, the Best in the Business

Learn Options Trading from the Najarian Brothers, the Best in the Business

All Investors Can Trade Options, Just Ask the Najarian Brothers WATCH VIDEO

All Investors Can Trade Options, Just Ask the Najarian Brothers WATCH VIDEO