Study to Win (AAPL)

Apparently our foray last week into the realm of options education was a smash hit, with millions more signing on – and a goodly number of those offering to sell their first-born into Normandy slavery should we continue the class.

Not wont to disappoint (and in dire need of a little domestic help), we return today to the Options 101 tutorial, picking up roughly where last week’s lesson ended.

Lesson #2 – Kicking Butt

 

Options trading is an exciting pastime precisely because it’s so outrageously dangerous. And it’s for that reason that it attracts so many skydivers and other thrill-seekers – warriors who like their pain at high speed.

Unfortunately, these folk too often learn just how fast one can be separated from their savings.

options
It’s the leverage inherent in options that gives investors such a joy-spasm.

But before we get there, a quick round of vocabulary-building.

Options Demo #1

Consider the case of ABC stock, trading at $100 a share. Then consider the ABC February 98 CALL option, currently selling for $4.50. Of that $4.50, $2.00 represents the intrinsic value of the option – the option, after all, is trading $2.00 in-the-money (100 – 98). The other $2.50 is what’s referred to as time value. That’s the amount of money the option seller is demanding for the next seven weeks’ risk he’s taking. Together, intrinsic value and time value represent the full price of the option.

The seller’s risk:

The seller is risking the possibility that ABC will rise above $102.50 – his break-even price – by February options expiry, after which he’ll be in a losing position.

Howzat?

 

Let’s assume that at expiry ABC is trading in-the-money at $103.50. The option seller has to go into the market and buy the shares at the current price – $103.50 per share – and sell them at the contracted price of $98 (called the ‘strike price’ in options lingo). He thereby loses $5.50 per share (103.50 – 98). On the other hand, he collected $4.50 per share from the options buyer when he sold the CALL contract, so he’s really only out $1.00 per share (5.50 – 4.50).

The buyer’s risk:

The buyer is risking ABC closing below $102.50, an eventuality that will make him the loser.

How?

Let’s say ABC closes at $101.50 when February expiry rolls round. Since the options expired in-the-money, the options buyer’s account is credited with 100 shares of ABC, for which he pays $98 per share, as his CALL contract stipulates.

robin

That’s right, Bat-Brat. Which means his all-in cost for the shares is $102.50.

But the shares are going for just $101.50 – he’s out a dollar per share, or $100 per board lot.

jim

Truth is, we prefer to leave ourselves enough time so we never actually arrive at expiry, trading out of our positions early for a profit.

Yeah, yeah, profit! Tell us about that leverage business again!

 

You got it.

Options Demo #2

You can buy 100 shares of ABC at $100 a pop for the full cost of $10,000. The stock rises quickly to $107, and whoopsi-dumbo! You have $10,700, a profit of $700. That’s a 7% gain in a jif. Not bad…

Or, you can buy the aforementioned ABC 98 CALLs for $4.50 when ABC stock is at $100, and should ABC climb quickly to $107, your 98 CALL would be worth $11.50 ($9.00 intrinsic value and the same $2.50 in time value). That’s the very same $700 profit in your pocket, but you only risked $450 – not $10,000!

Hey, wait a minute. That’s awesome.
What’s the catch?

 

The catch is that ABC can fall back down to 97, too, and your options would expire worthless, leaving you out 450 bucks. Had you bought the stock for $10,000 and it fell to 97, you’d be out only $300.

knife

That’s right, Barclay. Goodbye.

Again, we generally trade out of our positions early in an effort to both maximize profits and avoid a quick turn that might leave us empty-handed – a happening that’s all too common in the options game.

So Don’t be Greedy!

 

One more detail before we trade real money

You’ll often see us buy and sell options on the same security. We’ll buy, for instance, the ABC 105 CALL and sell the 108 CALL.

Why?

Simple enough – to save money in case we’re wrong.

It’s called hedging, and it works like this –

Options Demo #3

The ABC February 105 CALL might hypothetically run $2.25, while the February 108 CALL sells for $1.05. We buy the former and sell the latter, and we’re debited $1.20 for the trade.

Let’s say that ABC then rises swiftly and closes at expiry at $110. We’re in the money $5 on the 105s and out $2 on the 108’s (remember, we sold them). Our take is $300 on $120 invested or 150%. True, our profit is capped – we can’t earn more than $300 on the trade (called the ‘spread’ between the two options). But we also avoid losing the full $2.25 had we just purchased the long CALL and things didn’t go our way.

Hedging.

It pays off.

scratch

You got it.

This week’s trade involves super-hyped tech developer, Apple Inc. (NASDAQ:AAPL), a company that has a great deal going for it (mostly, that people are willing to spends all they do for its overpriced products), though the stock looks fated for a near-term fall.

Before we get to the trade, however, let’s look at her chart –

aapl1515

This is Apple stock for the last six months. There are a couple of features that stand out here.

1. Consider first that the end of November brought with it an all-time high price and an overbought RSI read (in red).

2. Since then, price has trended lower and the short term moving average has folded over (in blue).

3. We note, too, that RSI just went sub-waterline a week ago, and MACD looks ready to take a dip today (black boxes).

4. Once that happens, we believe we’ll see additional selling pressure on the stock and expect a retreat to at least the 137-day moving average at roughly $103.

So how do we play it?

 

We’re going to institute a spread here – just like the one outlined above, except with PUTs

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Wall Street Elite recommends you consider buying the AAPL March 105 PUT for $4.30 and selling the AAPL March 100 PUT for $2.57. Total debit for the trade is $1.73.

Maximum profit is $500 less our costs. Maximum loss is $1.73.

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[mepr-rule id=”988″ ifallowed=”show” description=”executive_lounge_members_only”]

Wall Street Elite recommends you consider buying the AAPL March 105 PUT for $4.30 and selling the AAPL March 100 PUT for $2.57. Total debit for the trade is $1.73.

Maximum profit is $500 less our costs. Maximum loss is $1.73.

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With kind regards,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

See what people are saying...

  1. Al Fry

    Keep at it, I realy am learning what I thought to be a rather difficult field.
    Not being any genius, I may be a little slow but the subject interests me and I do wish to try Options.

    Regards ,

    Al

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