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A common question on many investors' minds this weekend is how do I protect my Apple (AAPL) profits in 2012 leaps as Apple heads into earnings next Monday. On the one hand, after seeing Google's (GOOG) meteoric 10% surge after earnings, it's hard to swallow taking profits especially if Apple ends up gapping up $20-$30 after earnings. Yet, on the other hand, there's the distinct fear that given Apple's huge 28.6% move since early September, great earnings results might already be priced in. (I'll be posting an earnings preview here soon).

There's also the recurring issue of option premiums contracting after earnings even if the stock moves up a few percentage points. It's often the case that while Apple might move up 5-10 points after earnings, the pricing of leaps tends to contract. The reason for this is the reduction in implied volatility. Priced into these premiums is the notion that it's possible that Apple can really start to take off after earnings. If that doesn't happen and Apple trades sidewise, the premiums start to come down quite a bit. We saw this happen in July earnings. While Apple popped on earnings, premiums started to contract quite substantially. This despite the fact that Apple's share price actually rose.

There are all types of risks associated with holding any position in the equities market and those risks are even more accentuated when playing with leaps. For Apple in particular, there is a panoply of risks associated with holding leaps. For one, there's always the possibility that Steve Jobs could get hit by a bus. Look at how poorly the stock reacted with only rumors that Tim Cook might be going to HP (HPQ). Though the rumors were immediately proven false, the stock took a temporary $20 hair cut. And that's Tim Cook. Given that options by their nature have an expiration, and given that the market can remain irrational longer than anyone can remain solvent (Financial Crisis = Apple $78), there's an inherently much higher risk to holding leaps than straight shares which have a better potential for recovery.

There's also the risk that Apple may come in line or not beat by quite as large of a margin that many investors have come to expect. Just this past Friday, Senior Analyst Gene Munster at Piper Jaffray argued that Apple would only come in-line this quarter. If that happens, it will have a profoundly negative consequence on Apple's stock price given its nearly 30% move in little under two months' time. Right now, Apple is completely priced to perfection.

Essential to doing well as an Apple option investor is first understanding the risks involved in holding leaps, and how to properly manage that risk through some form of hedge or mitigation. Exactly how much risk mitigation is entirely dependent on the level of risk exposure each individual investor would like to assume. There are infinitely many ways one can reduce or increase their level of risk exposure.

First, one thing investors often do is just take profits in their contracts. Suppose one owns two January 2012 $300 call options at a cost of $30.00 each. Those contracts have now doubled in value as they closed at around $60.00 this past Friday. By selling one call option ahead of Apple's earnings for $60.00, that investor is now playing with the house's money. If Apple went to $0.00 at expiration, he or she wouldn't lose a penny in the overall principal cost of the investment - at least in theory.

Obviously, things aren't always that simple. The tax consequence could be profound. By selling half the position this year and the other next year, the IRS is going to come after the investor for part of the profits this year even if the overall position might actually break even. He or she could end up losing money on the transaction if he/she pays taxes on the imaginary profits that are lost in 2011. So it's not entirely risk-less unless both positions are closed out in the same year.

Secondly, another option investors consider doing is just selling their entire position and trying to get back in at a cheaper price. Yet, by doing this, you run the big risk that the stock just continues to run without a pull-back. By trying to trade in and out of the position, one could get completely priced out of the stock. So that's one risk that should be mitigated if the investor truly wants to participate in the stock. It is key to remember that hedging is a two-way street. One must effectively hedge against both a move up and a move down. But trading in and out of a position could be the level of risk appetite that some are willing and ready to take. It all depends on the individual.

Another hedge a lot of very advanced and sophisticated investors consider is a call-spread. This is probably one of the more complex but efficient ways to hedge a position with several potentially profound consequences. However, it's also really reserved for very sophisticated investors and should only be considered in close consultation with a professional financial advisor. For those investors who have a very high working knowledge of options and long term leaps, call-spreads are probably the best way to protect profits while being able to continue to participate in a stock's future move.

Suppose John Doe were to purchase two (2) January 2012 $300 Leaps on Apple at a price of $25.00 a contract in early September before this huge move up ahead of October earnings. As of Friday, those Leaps closed at a price of $60.00 a contract. The cost basis was $5,000 total or ($2,500 a contract). Today, they're worth $12,000.00. That's quite a huge gain - nearly 120% in just a little over two months' time. Now as we noted above, one thing John could do is just sell half the position and play with $6,000 of the house's money. Not a bad option at all.

Yet, if John wishes to continue his full exposure in Apple, but would like to reduce the total risk without selling half his position, he could consider selling one or more calls against his position of the same strike date. For example, he can create something called a "call-spread" by selling the January 2012 $400 call options to substantially reduce the risk to his principal investment.

On Friday, the January 2012 $400 call options on Apple were trading around $22.00 a contract. By selling two of these call options (Sell to Open), against his two $300 call options, he would bring in $4,400 into his account, thereby reducing the total cost basis for the whole position to only $600 ($5,000 original investment - $4,400 for selling the $400 call options). Basically, he's essentially shorting the $400 call options and covering that short position by owning the $300 call options. That way if Apple goes to $75,000,000 a share, he's protected all the way up with the calls he owns.

Remember, his original cost basis was $5,000 (two contracts at $25.00). Now instead of $5,000 of principal being at risk, only $600 of principal is at risk. This means that if Apple went to $0.00 at expiration, he would only lose $600 as opposed to losing his $5,000 original investment. This is a very good way to protect against Apple missing on earnings, Financial Crisis II, correction off of QE2, Steve Jobs getting hit by a bus, and any number of risks that could conspire to bring Apple down.

It also protects a lot of the profits. If Apple were to fall on earnings, by selling those contracts, it dampens the premium loss as the spread contracts. Instead of losing straight premium, at least by shorting the $400 call options, he's making some of that money back, right? For example, if Apple fell $10.00 on earnings, his $300 call options would probably fall $10-$12. But his $400 call options he's shorting would also fall maybe $7.00. That means he would only lose $5.00 of premium instead of losing $12 on the sell-off. He gains $7 for shorting the $400 calls and loses $12 for being long the $300 call options.

So this looks great for protecting a position, but what are the consequences on the total profits? Well by selling two $400 call options, John has given up any and all profits above $400 a share. If Apple went to $1,000 a share by 2012, all his gains would be capped at $400 exactly. John is essentially saying that he doesn't think that Apple will go above $400 on January 2012 and that if it does, he's happy taking all of his profits at $400 a share.

What does this mean exactly for the calculation of the spread? Well it essentially means that John cannot make more than $19,400.00 if Apple closes at or above $400 next year and can't lose more than $600 of his original investment. Max gain = $19,400.00; Max loss = $600.00.

Remember, by selling those two $400 call options, it literally means that John is in for a total $600 investment. Not the $5,000 he originally invested back in early September. The $4,400 actually goes into his account and is free capital that he can use however he wants. This also means that the $600 investment could potentially yield 33 times his investment. That's a 33-bagger!

Mechanically, this is how it works: Let's suppose Apple closes at $430 in January 2012. His two (2) $300 call options would be worth exactly $130 a share a piece. The two $400 call options he "shorted" would be worth $30 a piece. So he would be on the hook for $6,000 for the two call options he shorted and would gain $26,000 from the two $300 call options that he was long. He would pay out $6,000 to cover his short position and would get a net payment of $20,000.00 for the two calls that he owned. But he also already had $4,400.00 in his account in cash received when he sold the $400 call options. Now that brings his account total to $24,400.00. If we assume that John originally had $5,000 in his account when he started, that means his account went up to $19,400.00 - this is the total profit.

Just to give an idea of how this impacted his profits, consider the following illustration. If John decided to just go balls-out and unhedged all the way up to $430 in January 2012 with his original $5,000 at risk the whole time, here's what he would have made. His two (2) 2012 $300 call options would be worth $13,000 a piece, which brings his account total to $26,000.00 come January 2012. In this scenario, John lost out on an additional $1,600.00 in profits. At a $450 close on January 2012, he would have lost out on an additional $5,600.00 in gains. At a $500 close, John would have lost out in an additional $15,600.00 in gains. This is one major trade-off for hedging a position with deep gains.

Yet, there are still several other major draw-backs beyond just capping total gains when using a call-spread. Call-spreads offer very little flexibility for exiting with big gains on the run-up to expiration. They really only work best to exit after Apple has either already surpassed $400 a share or near expiration- which kind of sucks.

For example, let's suppose John does decide to sell the $400 call options at $22.00 a contract on Monday at the opening bell. Now if Apple reports mind-numbing numbers or comes out with some ground-breaking technology three days later and the stock surges to $360 a share, his $300 call options would probably rocket to $100.00 immediately. But the problem is, so would the $400 calls that he shorted. They would probably surge to $35.00. So now if he sold his entire position, he wouldn't have participated in most of the gains had he just held his $300 call options unhedged. If he just held his call options unhedged, they would have gone up to $20,000.00 from $12,000.00. But now, by being hedged, his total position only rose from $12,000 to $13,000.00. Basically, John just lost out on an immediate $7,000 of extra gains.

Essentially loss and profits on a call-spread is determined by the widening and contracting of the price spread between the two call options until expiration. As the stock rises, the spread widens and John makes money. As the stock falls, the price spread contracts and John loses money. So while he loses less if the stock tanks, he makes less on the immediate move up. So basically he has to wait until closer to expiration for the $400 premiums to contract considerably. Which brings us to the next big disadvantage to call-spreads.

Call-spreads do little to protect profits already built-into the original position. While it reduces the risk of the principal $5,000 investment down to only $600 at risk, what about the $7,000 in gains that John already has? While the spread protects those profits in the near term if the stock were to tank off of earnings, that spread will NOT protect John's profits if the stock closes below $300 at expiration. In fact, if the stock closes below $300 at expiration, John would only get the $4,400 that he made by selling the $400 call options. The other $7,600 that John already has is lost.

So what did we learn here? That (a) the spread will protect John's profits in the near term if the stock tanks after earnings as it will dampen some of the losses; (b) it will protect John against a cataclysmic system crash where everything goes to hell in a handbasket - at least he won't lose his $5,000 original investment; and (c) that John's immediate-term gains will be significantly hampered in the near term as he won't be able to participate substantially in any run up into the high $300 range until Apple either substantially breaks $400 well ahead of expiration or unless the stock is near $400 at expiration.

Still, there's no reason John couldn't employ more than just one strategy. Given that he has two call options, if he wanted to substantially reduce his risk, he could always sell one of the two call options and cover the other. For example, on Monday at the opening bell, if John could sell one of his $300 call options at $6,000.00, then he's already in for a $1,000.00 profit. The other $6,000, (house's money) that he has at risk can be covered by selling one $400 call option at $22.00 a share.

By doing this, he has now reduced his cost of that $6,000 at risk to only $3,800.00. Now only $3,800 of John's profits are at risk. He has essentially taken $8,200.00 off the table and is playing with $3,800.00 of his profits. In so doing, John has not only moved his principal investment of $5,000 to the sidelines along with $3,200 in profits, but if Apple goes to $400 by expiration, he would gain an additional $6,200 in profits.

Yet another strategy John can employ with a very high risk appetite is to cover just one of his two options. Instead of selling two $400 call options at $2,200 a piece, he sells only one call option against his two $300 calls that he owns. By doing so, John has reduced his risk exposure to $2,800.00 of his principal investment instead of $5,000. Doing this also allows John to participate in higher short term profits at the risk of losing more on the way down.

What this should outline is that for very advanced investors, there are a several ways to hedge going into a major event like earnings through the use of a call-spread. For the vast majority of independent investors however, it is probably always wise to simply take profits given the complexity and profound consequences that need to be closely monitored when entertaining the use of a call-spread.

One last major advantage to call spreads for those who are especially brilliant at timing the market is using spreads to trade around a core position until expiration.

Suppose John set up an account with the intent of employing the entire amount of capital ($5,000) towards an investment in Apple. In this situation, John could sell those two $400 calls for $4,400 on Monday and keep that capital in his account with the intent of employing that capital once Apple sustains a major pull-back. Let's suppose that after earnings, Apple sells-off substantially and the market also undergoes a major correction.

Further suppose that Apple tanks to $265 a share causing the $300 calls to fall back to $25 and the $400 calls tank to $9.00. In this scenario, John can buy one more more contract at $25, bringing his total position to three contracts and cash position $1,900.00. He can then use $1,800 of that capital to buy back or cover the two $400 calls that he shorted. Now John has three call options at $25 a piece worth $7,500.00. On the next move up, he can do the same exact thing, but sell three contracts to hedge his position instead of two contracts. For someone who is really good at timing the market, this is one way to build a major position while always being long the stock. That way if the stock keeps running, he's long and if it pulls back, it gives him an extra buying opportunity.

This is the strategy I'll be employing for a core position in Apple. As of last Thursday, 50% of my call options were covered, and as of the close on Friday I covered 75% of my total long position. I'm holding the January 2012 $350 calls and sold the 2012 $400 calls against my position. I'm very likely going to cover 100% of my position by the closing bell on Monday given Apple's substantial move since September.

Disclosure: At the time of this writing, the author is net long Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Source: How to Protect Apple Profits Ahead of Earnings