Getting Burned By Apple On Earnings

Apr.27.12 | About: Apple Inc. (AAPL)

It's impossible to stress certain points about options enough. Just like you cannot tell your kids to look both ways before crossing the street too many times, you cannot tell people new to options to:

  • Stay away from near-dated contracts.
  • Stay away from out-of-the-money, particularly deep OTM contracts.
  • Stay away from or do not proceed with earnings-related options trades without complete knowledge of the factors that could have an impact.

It's human nature, however, to make the types of mistakes that can hurt you on an options trade.

First and foremost, many of us have been hard-wired to go the route we perceive to hold the biggest bang for the buck. We want relatively low-risk for big rewards. Related to this somewhat primal urge, we prefer to capture those rewards by spending the least of amount of money possible. In some cases we have to take the bargain because we cannot afford the price you pay for the more expensive stuff. We do not allow ourselves to acknowledge the reality that if we have to ask how much it costs we probably should not be in the store.

And, third, some of us jump into situations wholly unprepared because we cannot resist the urge to make an assumed and eagerly anticipated quick buck. Plus, we look around and think, if that dolt over there is doing it, why can't I?

You're unprepared for an options trade if you have no idea what could happen between the time you put it on and expiration. In most cases, you do not need to know every single nuance of the why and how behind the what, but you should have a working understanding of the basics to consistently thrive and survive.

I have focused on Apple (NASDAQ:AAPL) options trades around the company's recent earnings report for several reasons. Obviously, it's a popular stock. But, more than that, over the last two weeks I have received several (yes, more than two) emails and private messages per day asking about the prospects of an AAPL options trade. Despite AAPL's massive beat and the stock's run back over $600, every query deals with a bullish, but losing trade or one that did not go quite as expected.

Generally, I do not publish entire conversations I have with readers; however, in this case, I think it will be instructive for the larger audience. This reader, without me even asking, suggested that I share his story. I agree with him that it can help whole hosts of others who have been, are or will be in the same or a similar situation.

Initial Message

My Initial Response

Nergock's Reply

My Reply

The Outcome

For whatever reason, the excellent site, BigCharts.com, I use for options charts does not want to give me a quote for the AAPL May $700 call. Not a big deal, though, as I can use the AAPL May $695 call to illustrate the key points. There's really little difference, other than exact price, between how the two functioned pre- and post-earnings.

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We should also compare this to AAPL's price history, courtesy of Yahoo Finance, picking it up from April 9 (when it hit its all-time closing high) and April 10 (when it hit its all-time intraday high). From there, the stock swooned, popped a bit on the 17th before downtrending to new (recent) lows and, ultimately soaring post-earnings. On the 26th, Thursday, AAPL closed at $607.70.

(click to enlarge)Click to enlarge

I will use my Options Investing Newsletter and several Seeking Alpha articles over the next two weeks to get into the technical particulars of why this call (you can use the May $695 or $700, there's really no meaningful difference between the two) acted as it did.

You might recall what I wrote earlier in the week in reference to implied volatility on AAPL May 2012 and January 2013 $500 calls:

Heading into earnings, the AAPL May 2012 $500 put sported IV of about 67. It dropped to 40 at the open Wednesday morning. Contrast this to the AAPL Jan 2013 $500 put, which saw IV drop from about 43.5 to around 36 overnight. Changes in IV at all strikes between the two expirations are pretty much constant across the board.

Fast forward to Thursday's close and IV on the May $550 is still quite a ways off at 45. While I do not recall IV on the $700 call pre-earnings, it experienced a similar decrease. As of Thursday's close, it's at roughly 33. It last traded for $0.92.

As we have discussed, IV tends to spike prior to earnings and drop, rather quickly, post-earnings. High IV equals lofty premiums, therefore when IV tanks, it takes call premiums down with it.

Maybe more importantly, however, is Theta or time decay. As of Thursday's close, Theta on the May $700 call is -0.1045. This means that for each day that passes, if AAPL's share price remains constant, that option contract will decrease in value by about $0.10.

While this might be counterintuitive to some, the rate of time decay will actually slow down on deep OTM calls as expiration nears, simply because there is no intrinsic value in the premium, only a small amount of time value. The same phenomenon operates on calls the deeper in-the-money they reside, as intrinsic value accounts for a majority of the premium.

At-the-money calls clock in with larger Theta because they contain more time premium than deeper ITM and OTM calls. For instance, at Thursday's close, the AAPL May $610 call checks in with Theta of -0.3687.

On a May $700 strike call, you need AAPL to move hard, fast and dangerously close to the strike or, more than likely, pass it to stand a chance of profiting on the trade Nergock put on with any reasonable amount of time remaining to expiration. Theoretically, on expiration day, Nergock would need AAPL to close at about $701.35 to just break even on calls he paid $1.35 each for.

Bottom line - IV and time decay often matter more than the directional move in a stock on and through earnings, particularly if you buy the "cheap" stuff by going OTM. Again, we'll cover the particulars of both concepts over the next couple of weeks. For now, I thought it made the most sense to get a conceptual feel for how things work.

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