A Major Pitfall All Investors Must Avoid

| About: Apple Inc. (AAPL)

While I've been investing in stocks and funds since I was a teenager, I've only been into options for the last 13 years or so. I think it was about halfway into those 13 years before I even made an options trade. While 13 years seems like an eternity to some, it underscores the reality that, while options can work incredibly well for long-term, relatively conservative investors, it takes a considerable amount of time to prepare yourself to employ even basic strategies.

Now, I am not saying every investor should wait 13 years before using options. In fact, I think most investors can start using simple methods after less than a year of study. Some folks might be ready in a matter of weeks or months. It's like anything else, different people go through different learning curves.

That said, one of the biggest mistakes investors constantly make is jumping in too soon, too hard and too fast. On a daily basis, I receive emails from readers that concern me quite a bit. On one hand, it's encouraging to realize that something I have suspected is indeed taking place - a growing number of retail investors are looking to make use of options. On the other, people consistently say things like this:

I am having a tough time getting my head around options, but I have this AAPL $600/$610 spread on that I wanted your opinion of.

or

I want to sell puts on AAPL, but I'm not sure if I select "sell to open" or "sell to close." And, come to think of it, I'm not sure if I am even approved to trade options in my account. Do I need to be?

These are real emails. I average a minimum of one to two just like these per day, easily. I highlight Apple (NASDAQ:AAPL) because, by a wide margin, it's the stock most investors inquire about. And I do not mean to poke fun at people in this article. Quite the contrary. I just think investors and much of the options industry treats the process of introduction to options in a potentially damaging, even reckless way.

If you do a spread like the one noted above on AAPL, or any other stock for that matter, you're on the hook for roughly $10,000 in margin. If you sell a naked put, multiply that $10,000 several times over. Even if it's cash secured, we're talking about $60,000 or so that you have tied up in your account in association with that trade. Quite a bit can go wrong. Even on something so basic as a long call, you can find yourself in serious trouble.

As AAPL has run, another popular email I receive asks about the prospects of buying calls. Everybody seems to want to go out-of-the-money. In and of itself, that can be a problem, but most of the people writing are doing it or want to do it with May or June calls. Some even flirt with April expiration. These investors have themselves convinced that Apple will blow the doors off of its next earnings report and the stock will follow, heading to $700 on the no-longer scenic route to $1,000. They might be correct. I am not saying these folks should not follow their conviction and make a bullish play. But, at the very least, stack the odds at least somewhat in your favor.

Consider $650 calls in AAPL. As of this writing, they trade for $6.50 in April, $17.30 in May and $22.50 in June. That's a considerable chunk of change to plunk down on a trade where you pretty much need everything to go your way, particularly with the April and May contracts. While the problem with going OTM and using close-in expirations is pretty straightforward, it's (A) sometimes tough to comprehend and (B) difficult to resist the allure of a "cheap" price tag.

Just look at the April calls. That $650 costs $6.50, whereas the ITM $615 runs $18.75. The deep ITM $500 call costs a "whopping" $115.35. Why the discrepancy? Why do the calls get more expensive as they go deeper ITM? Why does the same $650 call cost less with an April expiration than it does with a May expiration? It's all about basic probability that does not even require the use of many numbers for an explanation.

There's a better chance that the $500 call will end up ITM at expiration therefore it costs more than the $615. For the same reason, the $615 costs more than the $650. The same rule applies to why the less ITM or the further OTM these calls are, the cheaper they are. The deeper ITM a call is, the greater the chance it will finish ITM at expiration. You pay more money for better odds. Just like at a sportsbook.

If AAPL goes south between now and April (or May or June), the owner of an OTM call has very little to hang his or her hat on. As time decay becomes more and more of a factor, OTM calls trail off, with a seemingly hasty abruptness, to worthlessness. The further OTM, the harder and faster they fall, all else equal. If, however, you're in the $500 call, you'll lose some money if AAPL dips or dives, but you'll most likely just lose time premium or extrinsic value. You will be able to close the position prior to expiration and hang on to the intrinsic value of an ITM call - that's the difference between the strike price and market price.

In the April $500 example, of the $118.48 premium with AAPL trading at, say, $617.70 (the prices changed as I was writing this), $117.70 is intrinsic value, while just $0.78 represents extrinsic value. On the OTM call, there's no intrinsic value. And if that call floats ITM, much less of your investment sits "safe" than it does in a deep ITM call.

Intrinsic value. Extrinsic value. Time decay. Three pretty basic, but horribly confusing concepts. I say it that way because they're inherently tough for some people to grasp, but, once you know them, you know them pretty well.

New options traders and investors often make the mistake of not getting a handle on these basics before they dive head first into a trade on their favorite stock. It's even worse, however, when, before getting down less intimidating concepts like time decay, big talkers tell newbies that they "need to know all about Theta." While Theta is important, it's not a Greek that you must know if you cover yourself by purchasing ITM or ATM calls with expirations of, at the very least, 4-6 months out.

In this coming Tuesday's edition of my newsletter, we cover Theta. While it's an important factor to know with relation to time decay, I do not put the cart before the horse. When you're new to options you should work to mitigate the effects of time decay by going ITM, ATM and/or far out into the future with your expiration dates. Then learn about time decay as a basic concept before trying to understand the inherently more complex number that helps gauge it. From there, you'll be better armed to head down a riskier, possibly more sophisticated, but not necessarily necessary path.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.