24/7 Wall St.

“The market can remain irrational longer than you can remain solvent.“ —John Maynard Keynes

From friend of the blog—and Bullish Cross survivor—Kathy Corby:

Let’s do a little Options 101.  Don’t read this if you are a sophisticated options trader, but should you be considering some of the strategies discussed on this site, and are new to options, this is for you.

Buying an option confers a right; selling an option confers an obligation. If you buy call LEAPs, which are very long dated calls, you have the right to either acquire the shares at the specified strike price, or to sell that call back to the market, hopefully appreciated, at some point in the future.

But long options, being wasting instruments, decrease in value as time goes by and your purchase will be at a loss if the value of the stock does not exceed not only the strike price, but the sum of the strike place plus the premium which you paid for it. At times of high volatility, such as now, all options are more richly valued, and it becomes much more difficult to exceed that bar.

However, on the upside, A purchased call, such as a LEAP, has unlimited profit. A call spread risks less capital, since the sold call partly defrays the price of the purchased call, but does not have unlimited profit potential. Nevertheless, it is possible with a reasonable long call spread to double your money, or better, if the stock appreciates, and volatility has less effect since you are both buying and selling a call option, both fairly expensive at this moment in time.

In times of high volatility, selling puts is in general the preferred strategy. However the profit on the option itself, should you choose to sell it back to the market, is limited to the price which you obtain for the sale of the put. Further, if the stock declines below your sold strike price, the shares may be put to you.

There may be a price at which you would be delighted to obtain Apple shares, such as 180, but should there be a significant recession with a 40% pullback in the market, you would accept those shares at 180 even if they were valued at 140 on the open market. God forbid, but economists do expect such a pullback within the next one or two years, and Apple stock will move at least partially with the market. According to John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.“

Further, your broker will hold aside as margin the amount required to purchase the stock at the sold put strike price, and you may have better uses for that capital in the interim.

Selling a put spread limits your risk to the downside, and even should the stock price drop horribly, the long put in the put spread will offer you protection and limit your loss. To those of you who are new to options, you may wish to look into selling put spreads, which are appropriate to high volatility environments and have limited potential for capital loss.

Note: I personally was one of the victims of Andy Zaky‘s “Bullish Cross“ debacle*, which is well known to PED. I subsequently obtained an excellent education in options trading through a group called OptionsAnimal, which I would recommend to anyone wishing to become a sophisticated options trader.

*For an account for that painful episode, see The rise and fall of Andy Zaky at Fortune.com, with apologies for the scrambled layout. Maybe someday I’ll post a clean copy on Apple 3.0.