Here's Why Your Apple Options Trade Got Crushed Wednesday

 
on April 25 2013 8:16 AM
Traders signal orders in a bond options pit at the CBOT in Chcago
Traders signal orders in a bond options pit at the CBOT in Chcago Reuters

At Wednesday’s open, Apple (NASDAQ: AAPL [FREE Stock Trend Analysis]) started the day in the red and for most of the day, it stayed there.

Since the stock fell in value, options traders who had purchased calls or sold puts lost money. In other words, if you held a long options position, it wasn’t a great day for you.

But the shorts weren’t immune either. What should have been a little bit of a gain for those holding put or other short options positions ended up losing money too. If you traded the weekly contracts, you probably felt a bit more of the sting.

If you took an options position this week for the purpose of playing the earnings move, you probably put yourself in a no-win situation. Here’s why.

How Options Work

Options are hot right now. What better way to commit a relatively small amount of money to make a large profit. Risk a little, gain much is almost irresistible but as the cliché goes, “if it were that easy, everybody would do it.”

The truth is that options are complicated and there are extra factors that go into the pricing of the contracts. First, intrinsic value is the price relative to whatever the contract is tracking. If you own an Apple 400 Call option, it has an intrinsic value of $5.46 as of Wednesday’s close. Apple closed at $405.46. Your option allows you to by the stock at $400 which gives you the intrinsic value of $5.46.

There’s also time value. Every good options trader knows that they’re racing the clock. As the contract ages, it loses money because of the time value. This is why options traders don’t like to hold contracts that expire within 30 days unless they have a very short time frame. These “front month” contracts decay in value rapidly because of the loss of time value.

There are ways to measure how time value will affect the option but that’s for another article.

Implied Volatility

Intrinsic and time value are important but nowhere near as important as implied volatility. Implied volatility is the expected volatility of a stock over the life of the option. Notice that it isn’t the volatility of the options contract. This makes it a little easier to understand.

Think of it like this: Why did you trade those Apple contracts this week? Because you were expecting a big move in the stock post-earnings. You weren’t the only one that expected a big move. Hoards of other traders expected it too and that drove the implied volatility higher making the contract more expensive.

If you purchased an Apple option on Tuesday, you did the stock equivalent of purchasing at a 52 week high. Then, once earnings were announced Wednesday, the implied volatility dropped—a lot. Because the stock didn’t have a move as large as the implied volatility priced in, traders didn’t make enough money in intrinsic value to counteract the effects of the drop in implied volatility. In other words, those who traded Apple earnings, either lost money or didn’t make enough to justify the risk.

Real World Example

Minyanville wrote a great piece on this subject. On April 22, their analysis found that in order to break even on one certain Apple earnings trade, the stock would have to move above $429 or below $356. Just to break even, the stock had to move more than five percent. The author calculated the odds of that happening at about 20 percent. (Read the piece for a more detailed analysis.)

What’s the Takeaway?

In order to be a successful options trader you have to understand implied volatility. If you don’t, learn more about it, ask your broker where to find it on their site, and spend time watching how it affects the price of the option.

If you’re going to trade earnings using options (generally, not a good idea), put the position on before the implied volatility rises. Be one of the first to purchase the contract. If you would have put the trade on one week prior to earnings, you long position might have made more money.

Understand that while options are exciting, they’re very risky and much more difficult to understand. Successful options traders mitigate their risk by trading spreads, straddles, and other strategies. Learn and practice hedging strategies before committing real money to options.

Did you trade Apple earnings using options? How did the trade turn out for you?

Disclosure: At the time of this writing, Tim Parker was long Apple.

(c) 2013 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

 

Copyright Benzinga. All rights reserved.

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