How To Trade Apple Before Q1 Earnings

| About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) was cofounded by the late visionary Steven Paul Jobs and has completely transformed every industry it operates in. The focus on innovation has made Apple one of the largest and best performing companies in the world. I have recommended option strategies for 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.

As we enter the post-Jobs era, it is even more important to keep a close eye on your investment and execute care with your trades: since Jobs has passed the company's performance will be under a magnifying glass. Thus far Tim Cook has managed the Apple ship quite well but in such a dynamic industry, victory can be fleeting.

A brief recap of this week in Apple [Down $3.90 (-0.3%)]:

  • Apple Now Has Eighth Most Valuable Brand (January 16 BGR)
  • AT&T (NYSE:T) Increasing Prices of iPhone Data (January 18 Engadget)
  • Pearson (NYSE:PSO) To Sell $15 eTextbooks on iPad (January 19 Apple Insider)
  • Kodak Files For Bankruptcy Protection (January 19 NYT Deal Book)
  • Amazon (NASDAQ:AMZN) Reportedly Cutting Orders of Kindle Fire (January 20 DigiTimes)

Apple rose through Thursday when the company announced iBooks 2, the updated iTunes U, and the sale of eTextbooks. These catalysts will spur sales of iPads in the future but will likely not have a dramatic impact on near-term earnings. The partnership with Pearson and expanded electronic textbooks is going to be a bonanza for Apple as the economics of purchasing an iPad and eBooks are clearly superior to purchasing traditional textbooks every semester. It will not be easy to get all of the publishers on board but when it happens there will be little stopping Apple from dominating yet another industry.

Apple has pulled back approximately two percent from the new all-time high of $431.37 which was set on Thursday and I would not be surprised to see Apple retest the high before announcing earnings. Tomorrow Apple will report earnings for the first quarter 2012 which are widely expected to the best in the company's history due to very strong holiday iPad and iPhone sales. Playing Apple earnings is extremely tricky and essentially should be characterized as gambling. As I stated last week, the trade is essentially risk-on/risk-off.

I Like To Gamble, Bring the Risk-On

1. Go long Apple and be optimistic about its upcoming earnings

2. Buy AAPL Mar 2012 440 Calls as a leveraged way to gain exposure to Apple

3. Buy AAPL Feb 2012 OTM (440-460) Calls. This is essentially a lottery ticket type play. If you choose this investment you need to be extremely careful and monitor your investment closely as it can easily move against you in a matter of hours.

I Get My Gambling Rush From Penny Slots, I Want The Risk-Off

1. Go long Apple and sell weekly/monthly covered calls (for details see the end of this article)

2. Write weekly/monthly cash-secured puts that are approximately five percent out-of-the-money

I utilize different strategies for different quarters based primarily on how Apple has performed ahead of earnings. This quarter I will be conservative and sell Apple calls against 50% of my holdings and "let the rest ride". This is a solid middle-ground in which I am able to generate income by taking advantage of the high time value ratio while still maintaining the potential for outright stock appreciation. Kim Klaiman wrote a quite interesting article showing how ATM Apple options tend to underperform immediately after earnings due to the irrational exuberance that call buyers have.

In my experiences the returns have been better by expanding the time frame beyond a one day sample but the point holds true - time value always increases significantly before earnings releases. To summarize, selling calls is a high probability way to increases returns without sacrificing all of the potential upside. Investors only have to look at Google's (NASDAQ:GOOG) performance after the tech company missed both revenue and earnings targets. The stock tumbled 8.4% and made virtually all of the call options written worthless. I am not predicting such poor performance for Apple but why assume all of that risk if you can avoid it?

Below I present three possible scenarios and the potential returns for the Apple options. The first scenario represents a negative outlook for Apple while the final two scenarios are more reasonable. These scenarios are just projections and there is no guarantee that they will come to fruition. Even if you are optimistic it is important to generate both positive and negative circumstances in order to stress your assumptions.

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.

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 at the end of the week. Estimate where you believe Apple will close and select the strike price with the highest return.

With this information, executing a buy-write on AAPL January 27 (Weekly) 430s is the optimal risk-return strategy. If you are uncomfortable with this strategy I suggest a buy-write 420s, 425s, 435s. Even if you are extremely bullish you can still profitably sell covered calls; Apple is volatile enough that you will have opportunities to repurchase on dips. An alternative approach is to sell out-of-the-money 415 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 close out the position).

Disclosure: I am long AAPL, GOOG, T.