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I recently wrote a post in which I proposed the theory that shares of Apple (NASDAQ:AAPL) will see a very strong rebound in the new year.

In this post I will present some options scenarios gathered from the readers, along with one of my own, on how to play the expected rise.

Recap

Currently, Apple is down about 28% from its September intraday high of $705. There have been many reasons suggested for the swoon, and I covered these in the previous post.

In Part 2 I proposed that.

  1. Stock would continue to flirt with $500 until the end of the year.
  2. It will run to the $680-$720 range by Jan 18 (pre earnings release)
  3. It will then react to the earnings - (I expect a large positive).

[P.S. - I recently came across an excellent corroborating post by SA commentator Tradevestor.]

Counter possibilities

I presented some counter possibilities:

  1. Apple really is loosing share and experiencing severe margin compression.
  2. A drop below $500 might trigger automated selling by large funds.

A note from fellow SA writer The Financial Lexicon adds another potential serious headwind:

I think the capital gains issue has definitely been one driver of the sell-off (but not the only driver). I don't think it would shock anyone to see the stock rally into earnings. But a market-wide sell-off as a result of the fiscal cliff discussion could certainly have the power to mute any pre-earnings rally in January.

-----------

** ASIDE:

Dear experienced investors,

Please have patience with me. I assume that there are many people of different levels of trading experience reading this post, and I have therefore spent a little time explaining some things that you well know. Please - I am NOT trying to talk down to you, rather to include as many as possible in the conversation.

- Thank you!

-------------

The possible plays:

There are a large number of possible plays here. I will begin with the most conservative ones.

Play #1: Hogwash

You don't buy any of this. You believe Apple is going down.

Do nothing. You are guaranteed not to lose any money - but also not to gain.

Play #2: Options are too risky for me

A very intelligent idea. But you still want in? Buy Apple shares. You will have returns (or losses) precisely in line with the movement of the stock. If I am correct, the you will soon be smug about buying a huge dip.

If I should be wrong, and the price wallows around for another two months before finally rising sharply, and all the options traders have lost their plays, then maybe you can buy us all a beer in sympathy. Personally, I think Apple still has at least one good double in price before growth settles to a normal level.

Reader Isnylic comments:

Apple has all the fundamentals... buy and hold for the long term and you'll have a winner !!!! fundamentally, it's a sound stock …

OPTIONS PLAYS

Caveat: Options are risky plays. When purchased options expire if you are out of the money then you lose your investment. Period. It matters not if on the next trading day the stock soars past your target. Too bad.

If you SELL puts and calls, then the size of losses is potentially even higher.

Reader bailinnumberguy reminds us of Warren Buffet's pithy remark:

"Anyone who thinks that he can predict what a stock will do in the very short term, I'd hate to be his partner, but would love to be his broker."

Yet this is precisely what most options traders do.

Play #3: Leaps

Reader Robert McDonald wrote his strategy in part 1:

LEAP call options have expiration dates of Jan 2014 and Jan 2015. If you buy a 2015 LEAP with a strike price at the money (ATM) you will pay approximately 20% of the share price to lease the stock for one to two years. Big dips have usually never lasted more than a few months so if they do occur, you have plenty of time to recover and build your investment for the longer term, including the achievement of the long term capital gains rate by holding more than one year. [His whole note is well worth reading.]

Leaps are basically options with long term expiration dates. They give you the right to buy at a fixed price up until the expiration date. Therefore, if the price goes up significantly in the time frame, then you win. The advantage of Leaps, is that you have a lot more time for the price to rise. The disadvantage is that the cost of entry is higher.

Apple Leaps - Jan 2014

AAPL $513.41

Strike

Last

Bid

Ask

Vol

Open Int

510.00

70.80

70.35

70.95

13

1,174

610.00

36.45

35.70

36.25

2

4,812

710.00

17.40

17.00

17.55

11

2,763

910.00

4.20

4.20

4.55

120

1,769

Apple Leaps - Jan 2015

510.00

97.50

96.15

98.10

5

581

610.00

65.00

62.35

63.95

9

313

710.00

40.89

40.35

41.40

16

275

910.00

19.00

15.05

17.80

1

55

Play #4 - Complex strategy

Reader 1234gel writes:

I am not playing the earnings announcement in January, as many will be crowding this event. I am going out to April for my option plays ( April is traditionally the best month for bullish movement ), and have structured a bull call spread that will be executed before the FC resolution announcement - probably late in week, and I am paying for the spread with the sale of 2014 short puts - DITM [Deep In The Money - ed.]. After the January earnings, I will add another 2014 bull call spread, and sell Jan '15 short puts to pay for it. Since the plays are cost neutral, I will be very aggressive with my strikes, to allow for a significant upward move in share price.

Once again, he is using leaps here, but a similar short term strategy could easily be used with February, March or April options.

From Infopedia:

Definition of 'Bull Call Spread'

An options strategy that involves purchasing call options at a specific strike price while also selling the same number of calls of the same asset and expiration date but at a higher strike. A bull call spread is used when a moderate rise in the price of the underlying asset is expected. The maximum profit in this strategy is the difference between the strike prices of the long and short options, less the net cost of options.

[Note: I mostly ignore transaction costs in the discussion.]

Let's look at how this works. A table of call prices is below the fold. There are some call prices for Apple, strike date Feb. 2013 (Table from 26 Dec. 2012, Current price $513.53).

Let's look at strike prices of $525 and $535 and I will round the prices to even number of $25 and $20 for the sake of the argument.

If you buy just the $525 strike price calls @ $25, then

You have $25/share invested or 1 contract of 100 is $2500.

  • If the price goes to $625, then you will have earned $100/share minus your cost of $25/share, or $75/share or $7500 for each contract.
  • If, however, the price goes down, you lose all your $2500.

Now suppose you SELL calls of $535 @ $20, then

  • You will receive $2000.
  • If the price stays below the strike $535 then you get to keep it all.
  • But if it goes above $535 then you must sell 100 shares @ $535 no matter how high the price goes. If the price goes to $555, then your loss will be equal to what you received when you sold the calls. If the stock price goes higher, then you must pay out of pocket or sell shares you own in order to cover.
  • Losses are potentially very high.

Now suppose you want to bet on the upside, but you do not like the idea of losing $2500. You can BUY $525 calls @ $25 and SELL $535 calls @ $20. Now you are only out $5 per share (or $500 total per contract). Cool! So if the price goes down, you will lose only the $500.

BUT… The problem is, if the price is over $535 you have to sell those shares to cover the calls you sold. Let us say the price of AAPL goes to $600. The calls you bought at $525 are now worth $75, but the calls you sold with strike of $535 are now worth to you -$65. So you have a net gain of $10/share or $1000 for the contracts - double your investment. Meanwhile, if the price falls, then you are out your $500, but nothing more.

Thus the bull call spread will limit your risk (lower your cost), but will also limit your potential gain. You will never be able to gain more than the difference between the two strike prices. (Note, you will also need to deduct brokerage fees from your return.)

But this is not all, Gel has a further strategy: "…and sell Jan '15 short puts…" to reduce his cost to 0. By selling puts, he is gaining income and betting that the price will not go so low as to force him to cover those puts. The problem here in my mind, is that Gel is playing a risky game. When you sell a put option you are obligated to buy shares at that strike price no matter what. If the current price at expiration is over the strike price, then the put owner will not care to settle. But if the current share price is under the strike, he can buy for less and sell for more.

In our scenario, if you wanted to sell a put to make up the $5 cost of your calls, you would select the $425 strike price @ roughly $5. Now you have the potential to make $10/share ($1000/contract) and have nothing into it. Nothing. Nada. $0. Zip. Very cool!

But what if there is a catastrophe and Apple sinks to $325? Then you would have to buy shares for $425 when the going price is $325 - you would lose $100/share or $10,000 per contract! Not so cool. This is not a very likely scenario, especially with Apple already depressed, but in 2008 Apple dropped from a high of $200 (2007) to $80, a roughly 60% drop. Even from the high of $705, that would bring us down to $282. The result is pretty much disaster. I, for one, do not like to court disaster, no matter how improbable the outcome.

Play #4.5:

Reader lasvegasBrad suggests:

I would consider Feb. options, as I agree with previous commenter's about earnings happening after Jan options.

  • All Feb 2013:
    • Sell 480 put + $16
    • Buy 400 put - $3
    • Buy 550 call - $16
    • Sell 600 call + $5
  • Net about $2, risk only $80, and make up to $52 on that $80 [risk], and have an extra month for Apple to scream back.

What Brad has done is cover his risk buy also purchasing the $400 puts. This $3 insurance plan means he can lose no more than $80, should the sky fall in. If Apple share fall below $480, then he will have to pay out, but only to a maximum of $80 - the difference in the strike prices of the puts he sold and those he bought.

Note:

Brad, remember my scenario step #3 where there is a "sell the news dip" after earnings release. You may want to consider Jan. calls, close them out by expiry. Then buy new calls a day or five after earnings release (depending on how good the news is). This also gets you past the rather large pre-release premium on the call prices. (I have seen near term options drop 40% the day after an Apple quarterly report.)

The simple plan

There is also a very simple bull options plan. That is, you just buy call options that are at or above the money. Nothing else. The problem here is that your cost is the full cost of the calls. Your reward, however, is that there is no limit to your earnings. If you buy further out of the money, then you can lower the cost, although you risk the price closing just below your strike.

Personally, if the prices were the same on Dec. 31, or Jan. 2, and I wanted. Feb. calls, I would probably go for the $580s @ $8.60. I just have this aversion to paying over $10 for an option. Just a psychological thing, I suppose. Remember, no one says you must hold options until expiry. I try to close these out fairly quickly unless they go deep into the money very quickly. Made some money? Take it and run!

Conclusion

There are many reasons to discount Apple stock and rationalize the price drop. The question is, which of these are valid? If the varied reasons driving the current drop in price, should disappear, then the recovery scenario that I presented is likely to come true, and this will present a unique opportunity to the investor willing to take the implied risk.

There are many ways to play this presumption, from simple stock purchase to complicated options formulas.

Caveat:

**** This is all speculation, and not intended to be advice.

**** It is up to the individual investor to weigh the evidence for and against my hypothesis and decide for him- or herself whether it is plausible or not. Only then, then should they go forward and carefully prepare a strategy that meets their income level, their experience level, and their risk tolerance.

=========== The Fold ============

Strike

Last

Bid

Ask

Vol

Open Int

480.00

50.70

50.25

50.50

66

1,124

485.00

47.45

46.90

47.15

63

399

490.00

43.50

43.75

43.90

282

1,808

495.00

40.55

40.50

40.65

143

604

500.00

37.95

37.65

37.80

530

6,202

505.00

35.20

34.75

34.95

75

1,049

510.00

32.45

32.05

32.20

448

2,712

515.00

29.60

29.55

29.70

386

1,301

520.00

27.35

27.15

27.30

605

2,938

525.00

25.05

24.95

25.05

455

2,827

530.00

23.15

22.75

22.90

1,006

4,147

535.00

20.85

20.85

21.00

156

1,969

540.00

19.10

19.05

19.20

336

6,699

545.00

17.40

17.25

17.40

303

2,885

550.00

15.85

15.65

15.80

2,063

19,577

555.00

14.30

14.20

14.35

308

3,481

560.00

13.10

12.80

13.00

1,705

6,268

570.00

10.70

10.55

10.70

457

4,520

580.00

8.60

8.50

8.65

440

10,484

590.00

6.93

6.85

6.95

228

5,866

600.00

5.64

5.55

5.70

1,451

42,030

625.00

3.35

3.25

3.40

151

9,750

650.00

2.01

1.96

2.05

2,405

17,049

675.00

1.28

1.22

1.29

173

6,595

700.00

0.85

0.85

0.87

728

27,055

725.00

0.55

0.55

0.61

3

2,051

750.00

0.40

0.40

0.45

72

7,295

775.00

0.22

0.22

0.37

1

2,466

800.00

0.16

0.14

0.18

131

4,958

810.00

0.16

0.12

0.16

27

415

=====

Related Articles:

- Apple Physics - What goes down must go up.

- Apple: Of cults and cool, hype and sheep

Source: Apple Fire Sale: Part 3 - The Playlist

Additional disclosure: I may open long and/or short options positions in the next 72 hours or thereafter.