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As anyone who reads any of my stuff knows two of my biggest loves in life (other than my charming wife) are options and Apple (AAPL). While I expect the stock will get near $800 sometime in the next year, I have that gnawing feeling that it might fall by $50 or so (again) sometime between now and then. Heck, it almost fell that much over the last two weeks (until yesterday).

The investment world seems obsessed with the promises and the pitfalls of the iPhone 5. Some bears call it a cheap toy and some bulls believe it will take over China. As the rumors swirl around, the stock gets buffeted all over the place. No wonder Mr. Buffett doesn't buy tech stocks.

So what do I do if I own 100 shares of AAPL and want to protect myself against a $50 drop in the stock in the next 44 days? The answer is a simple options play.

With the options listed below in place, if the stock were to fall by $50 in the next six weeks, I would just break even. That seems a whole lot better than losing $5,000. It is comforting to know that I could handle a $50 drop in my favorite stock and not lose a penny.

If the stock were to fall by $40 over that time, with these options in place, I would make a gain of $600 rather than losing $4,000. If the stock were to fall by $30, instead of losing $3,000, I would gain $1,500. Not bad, in my book.

If the stock were to remain absolutely flat, I would make nothing on my 100 shares, but the options should gain $1,800, or about 18% on the $9,500 that it will take to add the options to my portfolio.

If the stock goes up, I am better off with both the stock and the options at all price points until the stock has moved $50 higher. After that point, I would lose only minor amounts on the options, but pick up thousands of dollars on the increase in value of my 100 shares.

Here is the risk profile graph for an option portfolio, which will be closed out on the expiration of the November options on November 16, 2012. At the time of writing this article, AAPL was trading at $670.

(click images to enlarge)

This graph assumes that the implied volatilities (IV) of the December puts will be the same as they currently are when the November puts expire, although an argument could be made that at they might carry a higher IV (closer to where the November options are now), and the projected gains might be higher (because the remaining puts would have a higher value).

These are the spreads that were placed in the portfolio that created the above risk profile graph:

There are two bull put vertical spreads in the November series, one contract selling a 640 put and buying a 610 put (maintenance requirement about a net $2,150), and three contracts buying 600 puts and selling 620 puts (maintenance requirement a net $4,850). In addition, you are buying two December - November calendar spreads (two contracts each) using puts at the 610 and 600 strike prices. The total investment works out to about $9,500.

You can select all sorts of spreads, depending on how far down you want to protect yourself. I picked the above spreads so that my stock could go down $50 and I would not lose anything. If I wanted further downside protection, I would have chosen even lower strikes for all the spreads, but I am basically an AAPL bull, and $50 protection was all that I felt I needed to buy.

Here is the summary table of the losses and gains from owning 100 shares of AAPL and having the above option spreads in place:

Change

Change

Stock

Change

In Value

in

Net

Price

From $670

of 100 Shares

Options

Change

$620

-$50

-$5000

+$5000

0

$630

-$40

-$4000

+$4600

+$600

$640

-$30

-$3000

+$4500

+$1500

$650

-$20

-$2000

+$4000

+$2000

$660

-$10

-$1000

+$2500

+$1500

$670

0

0

+$1800

+$1800

$680

+$10

+$1000

+$1300

+$2300

$690

+$20

+$2000

+$800

+$2800

$700

+$30

+$3000

+$500

+$3500

$710

+$40

+$4000

+$300

+$4300

$720

+$50

+$5000

+$100

+$5100

While it hurts to shell out another $9,500 in addition to the cost of owning the stock, I think it is a small cost in the long run. I will definitely sleep better with these options in place. I know that if the stock fluctuates by less than $50 between what it is today and what it ends up at on the third Friday in November, I will be better off owning these options in addition to my stock.

A final note -- many investors who are considering a foray into the world of options mistakenly (in my view) assume that any short options will be exercised (and you will end up being horrendously long or short shares of stock). Or if you are long options, you will have to exercise them at expiration and come up with a gazillion dollars. I trade options every day of the year and essentially never own or am short a share of stock. On expiration Friday, I will buy back (or sell) any in-the-money options I own or am short. In the options positions described above, early exercise is highly unlikely, and in the rare event that it does occur, should end up gaining you more money than you lose when you close out the other side of your spread the next day, and also close out the shares of stock you own or are short.

In short, options can be used to considerably reduce risk all around, and in the above case, they provide downside insurance that not only does not cost you anything, but results in additional gains almost across the board, no matter where the stock ends up. Surely, you can see why I am having a love affair with options.

Source: An Easy Options Strategy For Apple Bulls To Protect Against A $50 Drop In The Stock Price