How to Outsmart Apple Bears With Options

Mar.14.11 | About: Apple Inc. (AAPL)

This is the seventh article in a series on Apple (AAPL) option strategy. Apple is a unique company due to its combination of size ($325B), earnings growth rate (75%), and volatility (1.4β). This presents an exceptional opportunity for investors to capitalize on both its long-term capital gain prospects and short-term option premiums. For reference, please view the first, second, third, fourth, fifth, and sixth articles in the series to fully understand the strategy and its strong potential returns.


A brief recap of this week in Apple [Down $9.41 (-2.6%)]:

  • Steve Jobs Now 34th Richest in US; 110th in World (Forbes Mar. 10)
  • “Whisper Number” of 1M iPad 2 Orders This Weekend (Apple Insider Mar. 11)
  • Japanese Earthquake to Impact Electronic Supply (iSuppli Mar. 11)
  • Summary of iPad 2 Reviews (GizmodoMar. 12)
  • iPad 2 Teardown Analysis (Wall Street JournalMar. 12)
  • iPad 2 Launch – Long Lines and Sell Outs (Apple Insider Mar. 12)
  • Up To One Month Delays To Buy iPad 2 Online (Apple Mar. 13)

The highly anticipated iPad 2 was released on Friday to generally positive reviews. Despite some complaints about the camera quality, reviewers have been blown away by the improvements made by Apple. Most impressive were the combination of decreased thickness and increased speed. I visited an Apple store on Saturday to examine the “magical” device myself and saw that the store was completely sold out and was not even taking orders at the time. Anecdotally, there was a good mix of people looking at iPad 2s who owned the iPad 1.


A word of caution about the many iPad 2 surveys that you will likely read in the upcoming week: check the website and the sample size. There are already numerous unscientific polls being released by unreliable websites with sample sizes under 1,000. Do not put too much faith into stories, lines, etc. from single stores or sources. Apple is a juggernaut with $65B in annual sales; therefore, these little insights have minimal value for investors. Only focus on big surveys from trustworthy sources. Would you make an investment decision based on a poll of 200 random people standing on a line? I certainly would not.


With the uncertainty of the iPad 2 launch behind us, normally I would expect Apple to continue appreciating but there will likely be downward pressure this week. iSuppli issued a press release that is a must read for all investors. Setting aside the horrible loss of human life in the disaster, there will be implications for the supply of electronic components. iSuppli specifically mentions semiconductors, microchips, DRAM, and LCD panels as components that will be impacted. This means that Apple will likely face higher costs and larger delays, at least in the short-term. Apple is not alone facing these obstacles but should be better positioned than its rivals due to its long-term supply contracts. To summarize the situation:

The major impact on Japan’s semiconductor production is not likely to be direct damage to production facilities, but disruption to the supply chain. Suppliers are likely to encounter difficulties in getting raw materials supplied and distributed and shipping products out. This is likely to cause some disruption in semiconductor supplies from Japan during the next two weeks, based on the IHS iSuppli preliminary assessment of the situation.”

Below I present three possible scenarios and the potential returns for the March 19 monthly options (Source: TD Ameritrade). The first scenario represents a very negative outlook for Apple the next week while the final two scenarios are more realistic in my opinion. As a general rule, selling calls with higher strike prices has more potential return but more risk of loss due to the lower (or lack of) downside protection. For more information on the fundamentals of covered calls, read this excellent article on Investopedia.

Scenario 1: AAPL Closes at $334.39 (Down 5%)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$13.25

($4.35)

-1.24%

-90.21%

3.41%

345

$9.20

($8.40)

-2.39%

-174.20%

1.99%

350

$5.70

($11.90)

-3.38%

-246.79%

0.57%

355

$3.05

($14.55)

-4.13%

-301.75%

N/A

360

$1.42

($16.18)

-4.60%

-335.55%

N/A

Click to enlarge

Scenario 2: AAPL Closes at $351.99 (Unchanged)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$13.25

$1.26

0.36%

26.13%

3.41%

345

$9.20

$2.21

0.63%

45.83%

1.99%

350

$5.70

$3.71

1.05%

76.94%

0.57%

355

$3.05

$3.05

0.87%

63.25%

N/A

360

$1.42

$1.42

0.40%

29.45%

N/A

Click to enlarge

Scenario 3: AAPL Closes at $351.75 (50 Day SMA)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$13.25

$1.26

0.36%

26.13%

3.41%

345

$9.20

$2.21

0.63%

45.83%

1.99%

350

$5.70

$3.71

1.05%

76.94%

0.57%

355

$3.05

$2.81

0.80%

58.28%

N/A

360

$1.42

$1.18

0.34%

24.47%

N/A

Click to enlarge

Additionally, if you would like even more information, I have prepared a sensitivity analysis for absolute return and percent returns, respectively. After studying the information above, these two charts make it easy to pick a strike price based on where you believe Apple will close on Friday.

Apple Stock SensitivityClick to enlarge

(Click charts to expand)

Based upon the details presented above, I am of the opinion that executing a buy-write on AAPL and selling the Mar. 19 355s is the best strategy due to its risk-return profile. If you are uncomfortable with this level of risk, I would suggest utilizing the 350s. Conversely, to increase potential returns, the 360s may be a better choice for your individual strategy. As many great SA users have pointed out, an alternative strategy is to sell out-of-the-money puts on Apple and collect the premium without having to purchase the stock outright. Both the 345s and 350s are attractive for this purpose.

Disclosure: Author holds a long position in AAPL. Author plans to sell AAPL Mar. 19 360 Covered Calls.



Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.

Additional disclosure: Disclosure: Author holds a long position in AAPL. Author plans to sell AAPL Mar. 19 360 Covered Calls.