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Yesterday, Terry Allen wrote a detailed piece on how to make, in his words, "extraordinary returns on Apple" (NASDAQ:AAPL), and to a lesser extent the S&P (NYSEARCA:SPY), options. He detailed a couple of strategies: Multiple Calendar Spreads and Long term Bull Call spreads.

I'm afraid I am going to have to respectfully disagree with my fellow contributor both on these trades (see below) and with the central point; it is almost impossible to make the sort of returns alluded to on a consistent basis. Profits can be made - and I will give a couple of AAPL examples - but they have to be ground out over time.

Why options are difficult

Options are beguiling creatures. It is very easy to construct a trade, which may be very profitable in a short space of time with minimal capital. Or a weekly options strategy extracting time decay, that makes money for weeks in a row. And often these trades do come off.

But then suddenly they don't. That minimal capital is lost (its very minimal now). Or Spanish Bond yields go up which (somehow) blows up your in the money call option on Wal-Mart (NYSE:WMT). Or whatever.

The key problem is that options are usually fairly and efficiently priced over the long term. Without some edge a trader will break even over time on average. And so what form could that edge take?

Sources of Edge

The first is a reasonable expectation of where the stock won't go. Notice that I didn't suggest predicting where it will go; all we need to do is predict where it won't be after a certain (often quite long) time. Our IBM put selling strategy is an example: the trade assumes that the IBM won't go much below its current $195 price (and certainly not to $180). The second of the Terry Allen's trades - the long term bull vertical spread - gets close too (but is more of a bet on AAPL being higher, i.e. where it will go, rather than where it won't).

The second source is the ability to adjust. Options strategies can be adjusted whilst they are in the market to reflect current trading conditions. I'm not a huge fan of adjustments - I believe most positions that go wrong do so for a reason and should be taken off - but that is just personal taste. Many traders exploit the ability to guide their trade into profitability over time.

However I suggest the main source of edge is due to the mispricing of implied volatility (IV). Positions can be constructed to exploit this mispricing which can take many forms. Examples include:

Over confidence in the market in pricing risk

IV is really the way the market prices the risk of future market volatility. Sometimes it becomes too complacent - and IV is too low - which makes buying options attractive. The option seller has probably not been compensated fairly for future realized volatility and IV tends to mean revert: hence the bought options are likely to rise all things being equal. (The key issue is how long does this take; too long and theta will eat into the options value).

Irrational fear

The opposite is when the market is in "sell everything" mode. Out of the money puts - used to hedge long positions - are bid up causing excessive skew. This means that there is a large difference in IV for the OTM puts compared to, say, ATM. This can be exploited.

Overabundance of supply

Some options strategies are overly popular with, in particular, retail traders. For example the sale of weekly options on AAPL, GOOG, SPY etc on the Thursday/Friday they first become available - to exploit time decay - has become so popular that it now distorts options pricing. IV can be bid down by several percentage points and so taking the other side of the trade (as Jeff Augen, one of the top options writers, often suggests) can be profitable.

Events

Sometimes the options pricing methodology should be set aside as other forces, due to short term events, take over. The obvious example is earnings - when traders are more concerned with any gap after earnings and price accordingly. IV tends to rise before earnings (on average by too much) and this can be exploited. Likewise stock splits are often mispriced. And long holiday breaks (how would a market maker price the current 3 day Labor weekend break into options expiring this Friday?)

Specific strategies

These are just examples. No doubt readers could add more.

My concern with the two strategies presented is they do not attempt to take advantage of any of the above; in particular there is no discussion on volatility. I contend that few options strategies, or indeed options traders, can be profitable in the long term if no edge is identified before a trade is put on.

Anyway, all is not lost. Here are some of the specific ways you may be able to profit on AAPL options using some of the above:

VXAPL trade

You can repeat our successful AAPL trade. Whenever VXAPL - a measure of Apple IV - is below 25 buy a straddle, strangle or reverse iron condor. VXAPL should mean revert to 30+ and AAPL is such that it usually does so before theta kills the position.

Quarterly Apple Earnings

Buy a near term ATM straddle (or a strangle or reverse iron condor) before earnings and remove the day before they are released. On average IV increases to at least cancel out theta. And the position profits from any stock movement.

Sell new AAPL weekly options volatility

Sell weekly AAPL IV on the Thursday they come out (after the mad first hour). Buy back one hour before the close on Friday when IV should have reduced (all things being equal). Jeff Augen suggests buying and then selling a butterfly to protect against large stock movements.

Again these are just three examples (and are used as an illustration); readers will probably have lots more that exploit an expected edge. What they most definitely won't do is make "extraordinary returns on Apple options".

Source: There Are No Strategies For Making Extraordinary Returns With Apple Options