Trading Apple Options: Your Chance Of Success

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

Apple (NASDAQ:AAPL) is an interesting stock, and has as much widespread appeal as the company's products. Everywhere you turn, you can find discussion on the stock or the product. Is AAPL growth or value? Is iPad 2 better than Kindle Fire? I am certainly guilty of this, having written more about AAPL than any other single stock.

My prior articles have included option strategies for the “cautious bull,” the “hesitant bull,” the “flat out bull” as well as the "Apple bear.”

One common thread in all these articles is that I don’t take a position on whether AAPL is a good or bad buy. There are just too many good resources (especially SA) that the reader can research and come to their own conclusion. My articles simply explore various option strategies designed to meet a particular reader perspective.

Prior articles were all based on the premise that the “investor” either owned or wanted to own AAPL stock and was looking at options as a method to deal with risk/reward. They all involved a process and were not “one-off” trades. As such they may not have appealed to the “trader.”

The “trader” -- unlike the “investor” -- has no interest in owning AAPL. This is exemplified by high-frequency traders. It is said that some HFTs don’t even know the name behind the symbol. HFTs simply trade on momentum and look to make a little on each trade. The trader that I’ll address here isn’t that far gone. What they do have in common with HFTs is an aversion to actually owning AAPL, and instead look to make low risk-low reward trades and then move on.

This article will explore trading in AAPL with the expressed purpose of helping the reader decide if such a tactic should be part of his or her plan. I will also offer some suggestions on the types of trades that increase the chance of success.

Let’s make an important distinction between the “investor” and the “trader.” Suppose we have two investors that have researched AAPL and find value. The first investor already owns AAPL shares, and is at least a little concerned about a pullback. This investor doesn’t want to relinquish their shares, but wants to hedge and buys a put. The counter-party to this trade is an investor that wants to own AAPL shares but would like to buy it at a discount to the current trading price and make some gain if AAPL goes up. This investor sells the put.

It is my contention that no matter which way AAPL moves, it is a win-win for both investors. Each investor may have made more with a perfect guess, but they each accomplished their objectives. If AAPL moves down, the first investor profits on the hedge and the second investor buys at a discount. If AAPL moves, up the first investor just takes a small haircut, and the second investor makes a small gain.

This is why options work so well for investors that want to own stocks. As long as they match the right strategy to their situation, they always succeed. The option may make or lose money, but the bigger picture is in focus.

The dynamics are completely different for the “trader.” The object is solely to make money on the option trade. If we paired two traders, a party and counter-party, one must win and one must lose. If we paired two traders with identical abilities, in the long run they would be 50/50 and neither shows any gain/loss relative to the other (except for commission expense). Only the trader that is paired with a trader of less ability will show a relative gain, and always at the expense of the less able.

If we paired an investor with a trader, the investor always succeeds and the trader sometimes wins. That is why the investor always has an advantage over the trader.

One additional framework before we dive in: The price of AAPL is based upon supply/demand. The investor can look at fundamentals, technical, etc. and make a determination if AAPL is likely to move up or down. Options, for the most part, are not priced on supply/demand. They are priced on probability theory.

The formulas for determining these probabilities are very sophisticated. In simple terms, they can be measured by delta. The “Option House” makes sure all trades are either paired or they enter the market to assure that all positions are “delta neutral.” In doing so, the traders may win or lose, but the house always gets it spread.

With all this said, let’s now look at a typical AAPL trade. AAPL is trading at $363, and I’ll look at the January 2012 $370/$410 bull vertical call spread. That is buying the $370 call for a $20.25 debit and selling the $410 call for a $6.15 credit. The net debit is $14.10.

If AAPL closes below $370, the $14.10 debit is lost and that represents the maximum loss. If AAPL closes between $370 and $384, there are some losses, but less than the max. If AAPL closes above $384, there are some profits up to a maximum gain of $25.90 with AAPL at $410.

Now, one could look at this trade as “my maximum loss is $14 and my maximum gain is $26; I like it.” That is a little simplistic. Instead, we will look at the probability adjusted expected gain and expected loss.

It would be too lengthy (and too boring) to go into the statistical and probability theories and calculus necessary to compute all the possible outcomes. My prior article went into some more detail, so I will just give the results: The probable expected gain is $6.63. The probable expected loss is $7.91. The net expected outcome (gain minus loss) is a loss of $1.28.

We need to look at what this means in more detail. The cash outlay (premium debit) is $14.10 and the expected outcome loss of $1.28 means that every time this trade is made the trader loses almost 9%. Nice to be the house on this one. Now, it doesn't matter if you make this trade once and then move on to another stock to trade. The result is not unique to AAPL, and is always the same and sometimes worse.

But this doesn’t really tell the correct story. The trader brings knowledge and experience to the trade. They expect that their skill will win out, and it may. But exactly how much more skilled than their counter party must they be to succeed? I’ll shortcut the math, but it comes down to just under a 55% success ratio to break even. The success ratio needs to be 63% to earn a 10% return.

The less skilled counter party success rate, therefore, will be between 37% and 45%. So the skilled trader needs to be somewhere between 20% and 70% more proficient than the less skilled trader. Not impossible, but the bar is certainly set high.

Remember that this is the return on the cash invested. So, assuming a 63% success rate, the trade makes $1.41 ($14.10 debit times 10%). Make this successful type of trade every month and the total profit is $16.92 ($1.41 times 12). Since AAPL is trading at $363 this represents a potential gain of under 5% relative to AAPL’s price. Quite frankly, show me someone that gets it right 63% of the time, and I would think they could do a whole lot better than this if they picked stocks.

So, this begs the question: Would I rather rely on my skills to perform a 63% success rate or own AAPL and look for a 5% price appreciation? For those traders that want to rely on their skills, let’s see if we can improve our expected results by picking better options. Let’s take a simple example and look at the AAPL vertical bull spread with a different strike, say $370/$430. The $370 call still debits $20.20. The $430 call only credits $2.93 for a net debit of $ 17.27.

Getting straight to the chase, the expected gain is $7.29, which is better than the expected gain”of $6.63 in the previous example. The probability tells us what we would expect; the upside is greater so the expected gain should be greater. But that’s only half the story. The expected loss is $10.65, compared to $7.91.

The net expected result is a loss of $3.36. We knew it would be greater loss, but the magnitude of the expected net loss (nearly three times as great) surprised even me. I reworked the numbers and then even had to look at it logically to confirm the result.

So, what does this do to our success rate? We would have to raise it just above 59% to break even, and almost 69% to make 10%.

So, we find that the wider the vertical spread, the harder it is to make money. This should be critically important for the trader. What it tells us, is the trader can improve their probable outcome by “tightening” the verticals.

Actually, the most efficient spread from a probability standpoint seems to be $375/$390. The trader should keep this in mind as they apply their skills. For their skill is only what stands between them and losses.

In conclusion, statistical and probability analysis of option trading does not rule out the possibility of gains for the trader. What it does tell us, is if the trader has the requisite level of skill (or maybe luck) compared to others they can make profit. It also tells us that, in the long run, the trader needs to employ a fairly high skill level to make even a modest return when compared to share price.

For those traders that meet this profile, closer spread verticals may offer them a better chance of positive returns.

Disclosure: I trade Apple options.