In this article, I would like to discuss Apple's (AAPL) Implied Volatility and what it means to stock investors and traders. I take a closer look at how unique the current situation is and how can you take advantage of it.
Investopedia defines IV (Implied Volatility) as "The estimated volatility of a security's price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets."
Let's start by taking a look at the three-month IV chart of the SPDR S&P 500 Trust ETF (SPY):
Click to enlarge
The SPY has climbed from $120 three months ago to over $140 today. At the same time, the IV of the stock has decreased from 22% to less than 13% today. As explained in Investopedia, this is normal. IV tends to increase when the market goes down and decrease when the market goes up.
Now let's take a look at the three-month IV chart of Apple:
The IV picked up at 48% on January 23, 2012, before earnings. This is normal. It collapsed to 20% after the earnings, and bottomed around 19% on February 3. Such low IV means no real fear of the downside.
However, look what has happened since then. The IV went to 33% on March 5, just before the iPad 3 announcement. This is also normal. But after a brief decrease, it climbed back to the 40% region, which is not normal. The IV is "supposed" to climb in two cases: when the stock declines or before earnings. Now, we are still more than a month before earnings. So what's going on here? What does 40% IV tell us?
To me, it screams "danger". The stock just became too dangerous to trade. Some will argue the price is just "catching up" to become more in line with its incredible growth. Medium/long term, they might be right. Short term, a 50% rise in less than three months is just too much too fast.
Remember, the options markets are usually right about the stock. They reflect the "true" expectations of the traders. IV is one of the best measures of the future. When the IV is so out of line with the "normal" behavior, it is trying to tell you something. Just try to listen, it might save you a lot of money.
So what does all this mean for Apple retail traders?
If you are a long-term Apple shareholder, this is probably just noise. Keep holding your shares, ignore the noise - so long as the company can sustain its growth, the stock should do well. As a short-term trader, things are more complicated now. If you still want to play bullish, I would avoid buying calls at this time. They are just too expensive. Instead, how about a bullish long butterfly?
- Buy 1 AAPL April 550 call
- Sell 2 AAPL April 600 call
- Buy 1 AAPL April 650 call
The P/L graph looks like this:
The trade can be done for a $1,280 debit. This is the maximum you can lose. The maximum gain is realized if the stock is at $600 at April expiration. In this case, the trade will be worth $5,000. That's a 1:3 payoff. Of course, the probability of this happening is very low - as we know, risk/reward is directly related to the probability of success. But if the stock stays in the $590-$600 region for the next few weeks, the trade will slowly gain value. What is more important is the fact that the trade is vega negative - it benefits from decreasing IV. At some point, the April IV will have to come down, and it will benefit this trade. The breakevens at expiration are $562 and $637.
You might consider this trade if you remain bullish on AAPL and think it can sustain the $590-$600 levels in the next few weeks. I think this is the best way going long AAPL right now. With this trade, you are taking advantage of the inflated IV while staying cautiously bullish. You can be wrong and still make money.
For me, the AAPL options just became too dangerous right now. I'm staying on the sidelines till things calm down.