Using Options To Win With Apple, Up Or Down

Oct. 5.11 | About: Apple Inc. (AAPL)

There are certainly enough articles and opinions on what stocks to buy and when to buy them. It is not my intent to recommend any particular stock, but rather to outline one method of using options to buy into a stock.

There are thousands of stocks we can choose from, myriad options and myriad-upon-myriad option strategies. It is my experience that certain stocks are well-suited to certain strategies, so I am going to pick one type of stock and one type of option strategy and show how they can match up.

Before I go into this strategy, some option definitions would help. Let’s say a stock is trading at $85. The put option with a $90 strike trades for $7.00. The option is “in-the-money” by $5 ($90-$85). In option lingo, it has an intrinsic value of $5.00 (easy if you remember IN-the-money). Since the option price is $7.00 it has an intrinsic value of $5.00 and an extrinsic value of $2.00 (remember EXtra)

The type of stock that I choose to discuss is what I call the “sexy” stock. These stocks enjoy a lot of commentary and appeal. They are also high-beta stocks. An example of this type of stock would be Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), Priceline (NASDAQ:PCLN), Tesla (NASDAQ:TSLA) and Lululemon (NASDAQ:LULU). They all have upside potential but are “scary.” There are many more, but you get the picture.

So let me tell this story using Apple. I am not offering any opinion on Apple, just using it as an example. Today Apple trades at $380 and the new iPhone has just been announced. I do my research and decide that I like Apple as a long term holding and am willing to own this stock. On the other hand, I can expect crazy near-term swings and don’t know if now the best time to be buying. It is the classic problem: Do I risk entering too late or too soon? Seldom is it ever “just right.”

In this situation, I would like to capture upside if the stock takes off, but really would like to wait for a more opportune price. This is the perfect situation to use an option ladder, an option strategy that consists of buying or selling options on a given stock at different strike prices.

The first part of any option strategy is to determine the option expiry date. Once you understand the strategy, you can play with various dates. This strategy works well with six- or nine-month expiry. Three months seems a little close and one year a little long. For this example, I choose the April 2012 expiry.

Next, I determine the strike prices. There will be three strikes, and here’s how I choose them:

  1. I buy a put at-the-money. The $380 April 2012 put for Apple costs me $48.35.
  2. I sell a put below-the-money. The strike price is chosen so that the option credit will be equal to one-half the cost of the Step One put. Looking at the put matrix, the April $325 put sells for a credit of $ 25.25 -- slightly more than one-half, but good enough. This is $55 below-the-money ($380 minus $325).
  3. I sell a put in-the-money (above the current price). I choose this strike price so that it is in-the-money by as much as the Step Two option was below-the-money. The Step Two option was $55 below the money, so this will be $55 in-the-money or at $435.The April 2012 $435 put sells for a credit of $79.90. Since it is in-the-money for $55, the extrinsic value of this put is $24.90 ($79.90-$55).

As an alternate method, I could choose the strike price so the extrinsic value of this option equals one-half of the at-the-money put I bough in Step One. On high-beta stocks, it’s close either way. My goal is to have the extrinsic value of the two puts I sell equal the cost of the at-the-money put I buy.

First, what if in April 2012 Apple has gone nowhere and is still right at $380?

  • The $380 put expires worthless. This costs $48.35.
  • The $325 put expires worthless. A gain of $25.25.
  • The $435 put gives back the intrinsic value of $55, but the extrinsic $24.90 is gain.
  • Net result: Cost $48.35 minus $25.25 minus $24.90 equals profit of $1.80.

What happens if Apple goes higher?

  • The $380 put expires worthless. This costs $48.35.
  • The $325 put expires worthless. A gain of $25.25.
  • The $435 put gains intrinsic value all the way up to $435. Plus the extrinsic value of $24.90.
  • Net result: Profit of $1.80 plus whatever amount Apple closes above $380, up to maximum of $55 more.

What if Apple moves down? This is a little more complicated.

  • The $380 put fully protects downside risk on the $435 put that was sold.
  • It makes the same $1.80 on the extrinsic costs.
  • If Apple closes between $380 and $325, I makes the $1.80 extrinsic profit. I can abandon Apple, buy it now, at its price below $380, or commence another option ladder.
  • BUT if Apple closes below the $325 put I sold, I’ve bought Apple at $325.

In summary, I put myself in a position to fully profit on a move from $380 to $435. If Apple goes down, I lose only if it goes below $325. I can always decide if I want to purchase shares or reset another option ladder, or make another move.

It is essential to keep in mind that if I was very optimistic about Apple and thought it would go sky-high, this is not the best strategy. This strategy is applicable for stocks you would like to own, but are apprehensive about owning. It gives you a reasonable upside and allows a lower purchase price if it goes down. And though this strategy could be employed with any stock, it is best suited to high-beta stocks.

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

Additional disclosure: I may buy and or sell puts on Apple, Google, Amazon or Priceline.