Apple Is Thriving While Competitors Scramble: Potential Options Scenarios

Mar.28.11 | About: Apple Inc. (AAPL)

This is the ninth article in a series on Apple (NASDAQ:AAPL) option strategy. Apple is a very 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, sixth, seventh, and eighth articles in the series to fully understand the strategy and its strong potential returns.

A brief recap of this week in Apple [up $15.55 (4.6%)]:

  • Grand Central Apple Store Plans Cancelled (NY Observer March 21)
  • NY Times: NFC Back in iPhone (New York Times March 21)
  • RIMM Playbook Launching April 19 for $500 (Apple Insider March 22)
  • Foxconn Rumored to Build Apple Exclusive Plant in Brazil (Forbes March 22)
  • Samsung Announced iPad 2 Competitor (Engadget March 22)
  • Steve Jobs To Testify in Real vs. Apple Lawsuit (Wall Street Journal March 23)
  • Top Mac Software Engineer To Leave (Wall Street Journal March 24)
  • iPad 2 Shipping Delay Reduced to 2-3 Weeks (Apple March 24)
  • Motorola To Release New Xoom in 2010? (Unwired View March 24)
  • Impact of Japan Disaster on iPad 2 is “Modest” (Apple Insider March 25)
  • Apple To Potentially Owe $1B in Royalties to Kodak (Wall Street Journal March 25)
  • Apple Wins Patent Dispute Against Nokia (Wall Street Journal March 25)

Apple recovered much of its losses from earlier this month on the heels of good news. The week was kicked off with the announcement of AT&T’s (NYSE:T) planned acquisition of T-Mobile and the good news continued from there. Not only did the iPad launch globally but the delays in the US are being reduced. I still firmly believe that consumers will wait for the iPad 2 rather than buy a rival tablet. Despite launching two weeks ago, there are still lines of people outside of Apple stores waiting to buy the iPad. How many other companies can you think of that have consumers who are so supportive of the brand? The iPad’s true impact is evident from reviewing competitors' actions:

  • Samsung has accelerated the development of its new tablet
  • Motorola (NYSE:MMI) is rumored to be releasing a “Xoom 2” later this year
  • Research in Motion (RIMM) is opening the Playbook to Google (NASDAQ:GOOG) Android apps

Ladies and gentlemen, this is a sign that competitors are getting desperate. As both the iPod and iPhone have shown, once Apple gains momentum with their products they are impossible to stop. Companies are realizing that 2011 may be their only chance to stop Apple from dominating yet another consumer electronic category. For example, investors’ responses to Research in Motion’s earning announcement indicate that there is little confidence in the company’s strategy going forward.

The only negative news this week was that Apple could owe Eastman-Kodak (EK) royalties for patent infringement. EK won its appeal and has been quite successful in defending its patents in the past so the odds of Apple succeeding are low. In related news, Apple emerged successful against Nokia in a similar lawsuit.

Below I present three possible scenarios and the potential returns for the April 1 weekly 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 $333.96 (Down 5%)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$12.95

($4.63)

-1.32%

-96.08%

3.28%

345

$8.90

($8.68)

-2.47%

-180.18%

1.86%

350

$5.40

($12.18)

-3.46%

-252.86%

0.44%

355

$2.82

($14.76)

-4.20%

-306.44%

N/A

360

$1.28

($16.30)

-4.64%

-338.42%

N/A

Click to enlarge

Apple April 1 Sensitivity AnalysisClick to enlarge

Scenario 2: AAPL Closes at $351.54 (Unchanged)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$12.95

$1.41

0.40%

29.28%

3.28%

345

$8.90

$2.36

0.67%

49.01%

1.86%

350

$5.40

$3.86

1.10%

80.16%

0.44%

355

$2.82

$2.82

0.80%

58.56%

N/A

360

$1.28

$1.28

0.36%

26.58%

N/A

Click to enlarge

Scenario 3: AAPL Closes at $343.3 (50 Day SMA)

Strike

Price

Return

Return %

Annualized

Downside Protection

340

$12.95

$1.41

0.40%

29.28%

3.28%

345

$8.90

$0.66

0.19%

13.71%

1.86%

350

$5.40

($2.84)

-0.81%

-58.97%

0.44%

355

$2.82

($5.42)

-1.54%

-112.55%

N/A

360

$1.28

($6.96)

-1.98%

-144.53%

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.

Based upon the details presented above, I am of the opinion that executing a buy-write on AAPL and selling the April 1 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. The 340s, 345s, and 350s are all attractive for this purpose. If I did not have an Apple position I would consider selling these puts. Think about it: would you be willing to receive $2 to potentially be forced to buy Apple at $345? However, always remember that if the stock goes down to the strike price, there is the obligation to buy the stock (or close out the position).

Disclosure: Author holds long positions in AAPL, GOOG, MMI, and T. Author has sold AAPL Apr. 1 and Apr. 16 360 calls.