How to Trade Apple and the Debt Ceiling

Jul.25.11 | About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) is a unique company due its size ($365B), earnings growth rate (125%), and volatility (1.3β). I have recommended option strategies on Apple since 2010, with tremendous results. For reference, please view the first and other articles in the series to fully understand the strategy and its strong potential returns.

(Click charts to expand)

AAPL Weekly ChartClick to enlarge

A brief recap of this week in Apple [Up $27.87 (7.6%)]:

  • ITC Rules For Kodak in Apple Infringement Suit (July 18 Reuters)
  • Apple Updates MacBook Air, Mac mini Lines (July 19 Apple)
  • Apple Reports Blockbuster Q3 Earnings (July 19 Apple)
  • Counterfeit Apple Stores Appearing in China (July 20 BirdAbroad)
  • Apple: Next Target $500 (July 20 Seeking Alpha)
  • Apple Board Looking Into Succession Plan (July 20 Wall Street Journal)
  • Apple Paid $2.6B For Nortel Patents (July 21 Apple)
  • China Mobile, Telecom, & Unicom Expected to Sell iPhone 5 in Q3 2011 (July 22 Bloomberg)
  • Apple Rumored to Bid For Hulu (July 22 Bloomberg)
  • Grand Central Apple Store Confirmed (July 23 New York Post)
  • China Launching Probe Into Fake Apple Stores (July 24 Wall Street Journal)

Unless you have been living under a rock, you saw Apple’s phenomenal third quarter earnings release in which it (a) beat all estimates and (b) setup the company for future growth prospects. You can ignore the sandbagged guidance per usual but focus on the comments from the COO and CFO that detail why Apple’s high growth will continue. I detailed four reasons why Apple is going to $500 last week:

  • Cheaper, Prepaid iPhone Closer to Reality
  • The Succession Wheels Are In Motion
  • Competitors Are In Trouble
  • Apple Is Still a Value Play – “Cash” Adjusted PE of ~12

In addition, next quarter should see the release of the iPhone 5 and possibly even the rumored iPad 2.5/3. With these exciting prospects ahead you need to own Apple; however, you likely know that the company goes through long periods of stagnation. This is precisely why selling covered calls is such an attractive strategy. While others choose to speculate that Apple will appreciate this week, you get paid to assume the risk of foregone profits. With the debt clock ticking, I want to be on the cautious side, even with Apple.

Below I present three possible scenarios and the potential returns for the July 29 weekly options (Source: TD Ameritrade). The first scenario represents a negative outlook for Apple while the final two scenarios are more realistic. As a general rule, selling calls with higher strike prices has greater potential return but additional risk of loss due to the lower (or lack of) downside protection. For more information on the fundamentals of covered calls, consult Investopedia.

AAPL Option ChainClick 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.

AAPL Sensitivity AnalysisClick to enlarge

With this information, executing a buy-write on AAPL July 29 (Weekly) 395s is the optimal risk-return strategy. If you are uncomfortable with this approach, I suggest utilizing the 385s or 390s. Even if you do not normally write covered calls, I believe this is a profitable strategy as forced profit taking. An alternative approach is to sell out-of-the-money 390 puts and collect the premium without having to purchase the stock outright. Note that if the stock declines to the strike price, you are obligated to buy the stock (or closeout the position). In the past I have recommended a short straddle but with Apple rising so rapidly I cannot suggest it at the current price because market-wide profit taking could cause significant loses.

Disclosure: Author plans to purchase AAPL and write July 29 395 Calls.