If you are like a lot of other option traders, you probably avoided trading Apple Inc. (AAPL) during its recent earnings announcement. Now that the volatility event is over, you might be looking to take an option position. Even though the company announced its earnings, there may still be some volatile action ahead. Just this past week, the stock dropped significantly lower after Credit Suisse made an announcement about the company allegedly cutting components orders for the iPhone6. Here are a few thoughts that should be considered on AAPL or any other position you may enter.
Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely in many instances. Much of this advantage comes from the ability to control positions that are equivalent to stock with far less capital outlay.
However, a less frequently discussed aspect of risk control is the ability to moderate risk by the careful and precise use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear by any means.
As a direct result, it may not be obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software that most brokers have is essential to plan the trade and decide the appropriate time at which to place a time stop.
As a simple example, consider the case of a short position in AAPL established by buying in-the-money December 120 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -660 for approximately $5,750 as I write this.
At the time of this writing, the stock is trading around $116; these puts are therefore $4 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $118 at expiration. The options expiration risk is $3,750 or more. However, if the trader takes the position that the expected or feared move will occur quickly—long before expiration—he could implement a time stop as well.
Using a stop to close the position if the stock gets to $118 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.
Options offer a variety of ways to control risk. An option trader needs to learn several that match his or her risk/reward criteria.
John Kmiecik
Senior Options Instructor