Using Options to Profit From Apple at $400

Jan.17.11 | About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) has continued its almost uninterrupted climb from around $80 in 2009 to $348.48 today, and there still appears to be plenty of upside remaining. Every new product release has been followed by a bit of skepticism about how large the effect will be on earnings. Would iPhone 4 be enough of an upgrade for the old iPhone users to go out and upgrade? How many laptop and iPhone users would see the need to spend $500 on a new toy and grab an iPad?

The answer has been that users still cannot get enough of Apple products. While skeptics will argue that the iPhone being sold by Verizon won't have a huge bottom line effect, the chances are good that this will be plenty beneficial. There won't be a cannibilization of sales for Apple's other products; it will only lead to higher competition for other companies, and will force RIMM to really upgrade their new Blackberry models.

Apple's revenue has increased over the last 3 quarters from $13.5 billion, to $15.7 billion, to $20.3 billion. Each quarter they are consistently able to beat revenue estimates, which is another reason that price targets continue to be revised upwards.

A year ago we were asking if a $250 valuation was possible, only to blow through that all the way to the Friday closing price of $348.48. Below is the 5 year chart showing that since crossing over the 50 day moving average in 2009, AAPL has yet to even touch back against it.

click to enlarge

Click to enlarge

Apple is trading at a a PE of 23 as of Friday's close, according to Yahoo Finance. With a current forward PE of 15.05 and a history of beating estimates, it is likely to be trading around 13-14 on a forward basis.

So, using forward PE, Apple will make approximately $24.85 per share in 2011. To give this a 20 PE, it will trade at the end of the year at $497. This is a return of 42% from Friday's close. I see using bullish call spreads as a great way to enhance the potential returns. To be conservative and give a margin of safety for an incorrect potential future valuation, I will use $400 as a 1 year target.

Using Friday's closing bid/ask spreads on options, the January 2012 $325/400 call spread cost is $32.80. Ignoring commission costs, this has a maximum return of 128.6% if it closes over $400 at expiration. There is a break-even point of $357.80 at expiration, and a slow amount of time decay due to selling the $400s. With some secured cash, selling the $300 puts as well can net $20.95 back to lower the overall cost to just $11.85. While a short-term pullback is possible, it is difficult to see Apple dropping below $300 in a year's time.

Based on each individual investor's level of bullishness, the call spread can be moved higher or lower. Those who are more confident in seeing $500 next year may be more likely to buy a spread such as the $350/450 which has a 223% maximum return if it closes over $450 at expiration. More conservative investors may use a $250/350 spread which has an expiration break-even of $316.35 and a maximum of 50.7% over $350.

Apple options have created strong opportunities for enhancing returns for long-term bulls in one of the most successful global companies, which continues to innovate and expand with a long way to go before approaching market saturation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.