How to Play a Plunge

This article originally appeared Jan. 29, 2014, on RealMoney.com. To read more content like this, plus see inside Jim Cramer's multi-million dollar portfolio for FREE -- Click Here NOW.

Most people freeze up when a stock they like gets crushed on the opening. They often lack the courage to take a position until they see how the stock settles out. Once that happens you can feel surer that you are not "catching a falling knife."

If all you are seeking is a decent return on investment, waiting can mean missing the best time to trade. That's especially true if you are option savvy. Option premiums are highest when volatility spikes. Buying shares while simultaneously selling both call and put options can establish a wide band of profitability.

This is a powerful technique if you are convinced "the damage has already been done." Apple's (AAPL) gap down provided a great opportunity to profit from the drop that took place after their latest earnings report.

At 11:37 a.m., the shares were quoted at $508.60 with about $37 available for sellers of a July 19, 2014, $500 call and a premium of $32.60 for writing the same expiration's $500 put.

Here's the simple math on the buy-write combination for the five and a half month period until expiration.

Owners of Apple shares will earn at least one $3.05 quarterly dividend (goes ex Feb. 6) and perhaps two if the July $500 call is not exercised early. The numbers below conservatively reflect only one payment.

If Apple remains above $500 on July 19:

  • The $500 call will be exercised
  • You will sell your shares for $50,000
  • The $500 put will expire worthless
  • You will have collected at least $305 in dividends
  • Final Position: No shares + $50,305

Net Gain: $50,305 - $43,946 = $6,359 or 14.4% cash-on-cash in just 171 days

If AAPL closes below $500 on July 19:

  • The $500 call will expire worthless
  • The $500 put will be exercised
  • You'll need to buy another 100 AAPL
  • Another $50,000 in cash will be required
  • You will have collected at least $305 in dividends
  • Final Position: 200 shares + $50,305

Net Cost: $43,946 + $50,000 - $305 = $93,641 / 200 = $468.21 /share

Note that the best-case scenario will play out if Apple goes up, remains unchanged, or even if it drops down to $500. If Apple fails to hold $500... the break-even on the worst-case scenario allows for a further 7.9% decline, from the $508.60 trade inception price, without causing a loss on the trade.

A glance at Apple's six-month chart shows a similar looking sharp sell-off last September. That decline did not last long. Apple rallied from less than $450 to more than $570 within three months. The current pull back is likely to reverse quickly as well.

If your own investable assets do not allow for the large dollar position described, consider using Apple's mini-options which represent 10 shares rather than 100 per contract. The math is the same on a percentage basis.

At the time of publication the author held no position in any of the stocks mentioned.

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