In my last article from early December, I put forward a specific, short-term options-based strategy for making a bullish play on Apple (NASDAQ:AAPL) using a variation of a reverse calendar put spread. The goal of the strategy was to capitalize upon increasing price fluctuations and upward price movements in the stock, centered upon my prediction that AAPL would end up well above $370 by January 21, 2011 (the Friday before AAPL's Q1 2012 earnings release). When it was published, Apple was trading at $389; today, it is trading closer to $430. The result? A 39% return on capital (and 3-4% return on margin) in just over 6 weeks. Now that we've gone over the "how" and the "what" for this particular strategy in the last article, let's look more closely at the "why" in order to gain insight into how to successfully implement bullish, net-credit put spreads moving forward.
To refresh your memory, here's what we laid out in December:
Why are we bullish on Apple?
Apple is an incredible company with a downright sexy valuation; my thoughts on this can largely be explained by this article. A great valuation alone, however, can't be relied upon as an indicator of short-term stock price performance.
So why did we choose this short-term calendar put spread strategy - instead of just buying shares of Apple stock?
For several reasons - the simplest being that this strategy allows us to make a bullish play on Apple in which we know our maximum gain and loss, and have a substantially different risk/reward profile than simply buying long stock. When you buy a stock, there is often an equal chance it will rise or fall in value. In this strategy, on the other hand, we are willing to face a maximum loss that exceeds the maximum gain, because we are betting on an event where the odds are ostensibly greater than 50-50. My rough "expected return" calculation will help to better convey this idea.
Here are the other reasons we are choosing this particular strategy: Because Apple tends to rise before quarterly earnings releases; because this strategy does well when volatility is expected to increase; because premiums for January '12 Apple options seemed high relative to those for December '11 options; because this strategy is profitable even if the stock price stays the same, and allows us to closely approximate our minimum and maximum gains; and because this is a net-credit strategy, meaning the put option we sell has a higher premium than the put options we buy. In this case, the net-credit part means we get an excellent return on our investment if we are correct (small amount of capital required relative to the maximum gain); conversely, we face a maximum loss of about $600 if we are wrong. If you buy 100 shares of AAPL, on the other hand, you lose $600 if the share price falls by $6. Another reason I chose this strategy is because you are able to close out of it at any point. If you've already reached 70% profitability by December 13 - right before we had planned to "roll over" our December 17 put into a January 21 '12 put - you could simply accept that gain, close out of the strategy entirely, and move on to the next opportunity.
Finally, I considered our price expectation to be pretty conservative; Apple was trading at $389 at the time, and we sold a $370 put for $11.65 - meaning (for just this option) we might be forced to buy AAPL at $358.35. I put the odds at 75%-to-25% that Apple would wind up above $370 come January 21; that means the expected return on the strategy would be something like:
[(maximum gain) x (probability AAPL is at or above $370 on Jan 21 2012)] + [(maximum loss) x (probability AAPL is below $370 on Jan 21 2012) = ($400 x 0.75) + (-$600 x 0.25) = $300-$150 = $150.
$150 doesn't sound like much, but based upon the amount of capital required - approximately ((sold put strike price - bought put strike price) x 100) = (($370 - $360) x 100) = $1,000 assuming we rolled the December 17 $370 put into a January 21 2012 $360 put in order to pair it against the January 21 2012 $370 put we sold initially - that is a 15% return.
How it Went Down
Listed by date. The trades made on Dec 1, 2011 are detailed in my previous article. I provided instruction for how to complete the strategy - describing the trades that would need to be made after December 1 - but preferred to wait and list the real prices/dates at which I executed, as opposed to attempting to predict the future prices at the time. Moving down the table, each trade is listed in chronological order. Notice how on each day, the buying of puts is done before the sale of puts - this is to make sure that we aren't "uncovered" at any time. I've used colors to help match each "buy" to each "sell". Option prices are listed as per share. All positions closed as of 4pm EST January 18, 2012.
AAPL Put Spread Trade History by Date
|Dec 1, 2011||Buy 1||Put||Dec 17 2011||$370||$2.25||-|
|Dec 1, 2011||Sell 1||Put||Jan 21 2012||$370||$11.65||-|
|Dec 12, 2011||Buy 1||Put||Jan 21 2012||$360||$5.74||-|
|Dec 12, 2011||Sell 1||Put||Dec 17 2011||$370||$0.35||($190)|
|Jan 18, 2012||Buy 1||Put||Jan 21 2012||$370||$0.05||$1,160|
|Jan 18, 2012||Sell 1||Put||Jan 21 2012||$360||$0.02||($572)|
|Total Realized Gains:||$1,160|
|Total Realized Losses:||$762|
|Length of Strategy||49 days|
|Return on Investment||39.8%|
1Although this strategy is net-credit, meaning options sold cost more than total options purchased, that does not mean you can enter into such a strategy with zero capital. Capital required will be defined by your brokerage's margin requirements.
2 Margin Requirement = (Naked Put Writing) - (Credit)
Note: Certain brokerages have higher margin requirements for such options trades. With "paired" options strategies like this one, however - where you sell one option and buy another to cover it - your margin/capital requirement is typically equivalent to your maximum loss. This means that, to keep these requirements reasonable, you must always own a long put at all times you are short a put, no exceptions. Notice how I bought the December put before selling the short January put; and then purchased the $360 January put before closing out of the December $370 - all to avoid being "uncovered".
Follow-Up since Initial Trade
When we outlined the trade December 2nd, we were planning on "rolling over" the shorter-term December 17 2011 $370 put we had purchased at some point before it expired; this took place on December 12. Since Apple had already moved up quite a bit, we lost nearly the entire $225 we spent on that long December $370 put. The January 21 2012 put we had sold, on the other hand, had declined in value by about $4.00 - meaning we could have closed out of the entire trade at the time and still have posted a tidy profit of about $175 ([$4 x 100] - [$2.25 x 100]). Sticking to our guns though, we "rolled over" the December $370 by buying a January 21 2012 $360 put - which then covers our short January $370 put all the way until expiration - and then selling the now almost-worthless December $370 put for $0.35 per share.
Finally, January 18 2012 rolls around, and our strategy has now reached 99% profitability, because both the put we originally sold and the put option we last purchased are now worth almost nothing. Thus, there was only a tiny bit of money left to be earned by waiting until expiration. In our case, had we waited until expiration (assuming Apple is still well above $370), we could have made an extra $0.03 per share: the $0.05 per share remaining value from the short $370 put, less the $0.02 per share we would have lost from holding the long $360 put til expiration.
In conclusion, this can be a tricky strategy if you are just getting started with options, but can be very rewarding and is especially appropriate for certain circumstances. To me, there is always an advantage to being able to closely approximate your maximum gain and loss before entering into a strategy. If you like odds and probability - like assessing the probability that Apple, trading at $389 on December 2, 2011, would end up above $370 right before Q1 2012 earnings - then such a strategy might suit your taste and goals well. Maybe you think Apple is poised to go up over a certain time period, but don't want to spend $4,000 just to buy 10 shares; maybe you want to make a bullish play on Apple, but don't want to expose yourself to the risk of losing your entire investment. This same strategy can be used with essentially any expiration lengths, with different strike prices, and with different risk/reward profiles.
In using such a strategy, you are certainly committing yourself to more work and more brainpower than simply owning shares outright; you are now actively investing (especially if using an expiration as short as the one in this strategy), as opposed to passively investing. With more work however, there is often greater potential for return. After all, when you purchase shares in the traditional, long-only manner, you are essentially betting that a stock will rise in value; your profit/loss curve is a straight line, and your maximum loss equals your entire investment. So why not make the same bet, with a known and acceptable maximum loss, on more specific terms that you decide upon, while generating additional revenue from option premiums?
Disclosure: I am long AAPL.