How To Play A Legit Apple Pullback

| About: Apple Inc. (AAPL)

There are those who believe a legitimate apple logodouble-digit percentage pullback is inevitable near term for Apple (NASDAQ:AAPL), while others don't see it happening into the distant future if ever. Still, after the buyback announcement and pending weekend iPad launch sales it may cause many to wonder if a pullback is imminent.

Regardless of your position, there is a simple way you can make money if you believe as I do that Apple is headed higher but not in a straight line. A higher Apple is likely due to its bankable earnings growth and growing cash horde. I believe the fundamentals are just too strong for HIGHER not to be the ultimate direction from here. So, If you believe a pullback is coming or that Apple may take a breather and tread water for awhile, but also believe it's still a great buy, you may wish to review a few trading alternatives below. Select the one that best fits your thesis and risk tolerance. I'll provide a brief perspective on each alternative. Some will include a link to an article discussing that particular strategy. I'll conclude with where I am placing my money:

  1. Sell your Apple stock and wait for it to go down; then buy back lower.
  2. Buy Puts.
  3. Selling Calls: See Kim Klaiman's approach on this strategy.
  4. Sell Apple Puts: See Rocco Pendola's approach on this strategy.

The first alternative is risky in that it is essentially trying to time the market. Many have tried this approach recently with Apple and been burned. They either missed out completely or had to get back in and missed out on a portion of the spectacular ride up. Another negative of this approach is that it may adversely affect your taxes (unless your shares are older than twelve months). Still, the positives are obvious. If you do this method right though, you are either a genius or a very lucky trader who timed it perfectly, effectively beating the casino… And you still own Apple stock!

The second (Buying Puts) alternative does not have the long or short term tax consequences of the first and as such may be preferable. Being that an option is a leveraged bet, your payoff will be considerably larger on a percentage basis. You are paying for insurance with this approach and if you are a long-term bull you may be kicking yourself if the pullback does not materialize. Most other predicted outcomes including timing the market, are very similar to the first alternative.

The third (Selling Calls) alternative is one that could be the lowest risk as it allows you to potentially earn a time premium on top of your stock gains (if the stock goes up). It has risks though and one risk is that if you do not select a strike price far enough away (and Apple pops as it tends to do), then your shares may get called away and you are left with the tax hit from having to sell your shares (could be a short term tax hit too). You also will need to buy back in to follow your original thesis that Apple is going higher. The key decision here is how much higher you feel apple could possibly move and over what time frame. As an example, if you feel that Apple is running out of steam and do not believe that Apple has catalysts in the pipeline that will cause it to go higher than say 650 prior to Oct. 20th 2012 then you could capture a $33 premium/contract (or $3,300) as of Friday but more likely closer to $45 - $50 (or $4,500 - $5,000) when the markets open today. In this case you also gain the entire stock price appreciation from here to $650.

The fourth (Selling Puts) alternative is a Bull's friend and I shall explore two approaches within this alternative, each with differing "degrees of safety". The requirement here is that you must have cash available in case the stock drops enough so that you are forced to buy the shares. Though some may have the proper option approval I will not delve into the naked (or margin) approach to selling puts as I feel it favors the intermediary providing you the margin loan. In any event, depending upon which of the two alternatives you choose below, the risk can be a higher or lower risk than alternative three above. The idea here again is to select an appropriate strike price and timing for when you think Apple's stock price will go down, stay flat or appreciate slowly.

Option A - If you are very confident that Apple will be going down near term (some may believe this due to the iPad launch catalyst has now occurred and addition to today's "what do we do with all this money" conference call) then you may want to pick a near term option, say the April 21st $600 strike price which as of this morning at 9:37am has a bid of $25.30. This means that as long as Apple is at $600 or above you will pocket $2,530 over the next 33 days. If you are selling (writing) this put there is the possibility that if Apple drops to around $575 that you will be forced to buy Apple at this $575 price ($600 - $25).

Option B - This strategy entails selling the Oct. 20th Apple puts at a strike price of $660.This approach has less risk than option A in the sense that you will participate in much more of the upside if in fact Apple continues it's march upward. The strategy here is to sell a put that is further away in duration and further above today's price for Apple's. Why would you want to do this vs. Option A? It's because though you believe that Apple will pullback, you are not confident as to when this will occur. The example here is to select the October 20th strike price of $660. In this case you would receive a premium of about $10,340 as of today's opening, this return will be in addition to the stock price appreciation up to $660 if you own the stock. It's a solid return rate as it is received for holding it over only a 215 days period. If apple drops at any point between now and the Oct. 20th call date, you can make money by cashing out of this position via buying back your puts. The longer you wait, the more you make as long as Apple does not jump beyond your $660 strike price. Again, if Apple plummets, you may be required to buy Apple at or near $560. But, if you are a long-term bull, this is probably something you would like to do (buy Apple on sale).

To further clarify how this alternative would affect you:

  1. If Apple ends up below roughly $560, you make no money and may be required to purchase Apple at $560.
  2. If Apple is between $560 and $660 on Oct. 20th you stand to make up to $10,340, which is the amount you make if Apple is exactly at $660 on Oct. 20th. (this will change slightly between now and publication)
  3. If Apple is above $660 on Oct. 20th you are guaranteed the $10,340 premium.

I tend to believe that with the recent price jumps due to the launch of the iPad and the cash deployment announcement, that a temporary leveling off of Apple shares will be occurring this summer. My recommendation is Option B as it provides an excellent way to both participate in significant upside while also providing some downside insurance you would not have if you were straight up long Apple stock.

So, SA readers, if you believe that Apple is a long term winner but also believe it may take a breather, consider these alternatives.

Disclosure: I am long AAPL.

Additional disclosure: I have sold deep out of the money puts in the past on Apple and am awaiting their expiration.