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Apple is the most undervalued and underappreciated large-cap growth company in America." -- Andy Zaky

Although I wouldn't go that far (GM (NYSE:GM) and ING (NYSE:ING) are looking pretty undervalued right now), I do agree that Apple is an incredible company with a significantly undervalued stock. For those who concur, what is the best way to proceed given the current market conditions? Do you simply buy long AAPL stock? Buy AAPL calls? Sell AAPL puts?

Though these are all ways to make a net-long investment in Apple, they are all unique strategies that are appropriate at different times. With all the good coverage on SA alone that addresses the question of whether you should invest in AAPL now, in this article we will be taking it a step further and focusing instead on how best to invest in Apple right now.

In a nutshell, the way we make a bullish investment in Apple should reflect our view of the current market conditions as well as our expectations for Apple's stock price. Each such strategy has its advantages and disadvantages. Let's briefly examine a few broad strategies:

Pros/Cons of Different Net-Long Strategies

Pros

Cons
Buying Stock
  • Less volatile than using only options
  • Less risk of losing entire investment
  • Good for long-term investments and for stocks with dividends
  • No leverage
  • Lower returns on equity than most options strategies
  • Poor returns in sideways markets
Buying Calls
  • Maximum loss is known in advance
  • Less capital intensive than owning stock outright; allows for greater returns with less money
  • Use for stocks expected to rise significantly
  • If stock declines below strike, options expire worthless
  • Call option premiums eat into returns
  • Avoid when call premiums are high
Selling Puts
  • Generates additional income from premiums
  • Selling one put has same maximum loss as buying 100 shares outright
  • Generates income even if stock doesn't move
  • Maximum gain = put option premium; no additional returns if stock skyrockets
  • Avoid if stock is showing bearish trend signs
Bullish Put Spread
  • Net-Debit Strategy (value of options sold > value of options purchased)
  • Maximum loss similar in magnitude to max gain
  • Generates income even if stock doesn't move
  • Maximum gain
  • Risk outweighs reward if put premiums are low

Now let's evaluate the current situation: The stock market is highly volatile, and AAPL premiums are high. It is likely AAPL will continue to have big swings, and it may wind up back where it is now after a big rally. What to do? Buying stock outright may not be profitable for a while given the swings, and buying even 100 shares of AAPL is very capital intensive. Buying calls would work, but premiums are incredibly high (a January $370 AAPL call option is $30). Selling puts would also work, but I'm not willing to bet that AAPL will only move upward in the near-term.

Bullish put spreads sound most appropriate; this will allow us to generate income from premiums even if the stock doesn't move, and allows us to capitalize upon high options premiums. Also given the uncertainty in global equity markets as a result of the Euro crisis, short-term strategies may be more appropriate than longer-term strategies, and options can suit any time horizon.

So here is what we're going to do: Sell a January 21 2012 $370 put for $11.65. With this short put alone, our break-even point come January 21 is $358.35. Is it possible AAPL will wind up below that? Definitely. So to cover ourselves, we will buy a put, but one with a shorter expiration in order to save money - let's buy the December 17 2011 $370 put for $2.25. Of course, this means that to stay "covered" until expiration, we will have to "roll over" the long (purchased) put into a January 21 2012 put before it expires.

What I like about this strategy is that, if things start going our way, we can simply buy back the short (January) put at a lower price and either sell the long put at a small loss or let it expire; as long as you buy back the January put for $9.40 or less, you cannot lose money (as the maximum loss on the December put is the premium, $225).

If things go against us and Apple's stock price starts falling, then we start making money from the long December put, and we can then sell this put option and use the proceeds to purchase a new put with a January 2012 expiration so that our short put is covered until expiration.

We will need a little extra cash on hand in case this happens, however, becase the January put we sold will increase in value (meaning increasing our loss) faster than the December put we bought, as a result of the further expiration. The trickiest part of this strategy is then "rolling over" the December put into a January 21 put sometime before December 17.

Thus far we have:

  • Sell 1 January 21 2012 $370 put for $11.65
  • Buy 1 December 17 2011 $370 put for $2.25

At this point, the net cost of this strategy is $9.40 (11.65 received less 2.25 spent). We are now covered until December 17, 2011; if we let the December 17 put option expire and fail to roll it over, we are now uncovered again, and we want to avoid this. Here's how we will roll over the December put we bought into a January 21 put - and remember, the point is to wait until we get close to December 17 to roll the option over, so that the cost of the January 21 put option we are buying to cover our short put is as low as possible. Here's how this might work come December 15:

AAPL is at $360: The $370 December put we bought for $2.25 is now worth about $11 - this represents a $875 profit on this put option (although if we were at this time to buy back the January put we sold, the loss on that would exceed this - which is why we are rolling it over). From here, we sell this December put and simultaneously buy a January 21 put with the proceeds. The higher the strike price for the new put we are buying, the lower the risk of loss, but expected profit is also decreased as higher strike puts are more expensive.

If you are feeling extra bullish on AAPL at this point, buy the $360 put for $6-7 or so; if you are concerned that AAPL will continue downwards and want to protect yourself more against further decline, buy the $365 put for $9 or so. If you wouldn't mind buying 100 shares of AAPL at $358, then don't bother rolling over the long put at all (this applies to all scenarios below as well).

If your stance has changed, and you are now bearish on AAPL, buy a January put option with a strike price above $370; this will turn the strategy into a bearish put spread (again, this applies to all the following scenarios as well).

AAPL is at $370: In this scenario, the December put we bought is now worthless. If the value of the January $370 put we initially sold is now less than $9.40, we can simply let the December put option expire, and buy back the January put. Conversely, we can spend another $3-5 per share on a January $365 put.

AAPL is at $380: In this case, the December put we bought is now worthless, and the January $370 put we sold is now significantly cheaper (more like $5). From here, we can simply let the December put we bought expire (loss of $225), and then buy back the January short put (profit of $665 if the put now costs $5). This is like stopping while you're up. Conversely, you can keep the short January put if you think AAPL will end up at or above $370 in January, and buy a $365 January put to cover it.

In conclusion, this is a valuable strategy, but it is time-intensive and can be difficult to implement. It is also important to note that, until you have covered the short (sold) put with a long (purchased) put with the same expiration, there is no maximum loss or maximum gain, as the execution price of "rolling over" of the long put will determine this. Bullish put spreads represent a net-long investment, and you will likely lose money if AAPL goes down.

This is far from a perfect strategy, but the more you become familiar with it the easier (and likely more profitable) it becomes. If worst comes to worst and you end up with an uncovered, near-the-money short AAPL put, you can't lose more money than you would had you had simply bought 100 shares of AAPL outright at the same strike price.

AAPL Key Stats

AAPL

Industry Average

Price/Earnings TT

14 12.3
Price/Book 4.7 4.5
Price/Sale

3.4 1.6
Price/Cash Flow 9.7 7.8
Revenue Growth (3 yr avg) 42.4% 6.3%
EPS Growth (3 yr avg) 59.8% --
EPS Growth TTM 82.67% 45.65%
Sales Growth (5 Yr) 41.16% 33.61%
Operating Margin % TTM 31.2 15.0
Debt Margin % TTM 24.0 12.9
Return on Equity TTM 41.7% 28.44%
Debt/Equity 0 0.2

Disclaimer: The strategies described herein do not constitute a recommendation to buy or sell securities. Investments in derivatives securities may result in losses greater than the total initial investment.

Source: Options Plays For Apple Bulls