Are Apple Investors Too Optimistic? Maybe

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 |  About: Apple Inc. (AAPL)
by: Paul Zimbardo

Another day, another fifty-two week high for Apple (AAPL). At this point Apple is an unmitigated market juggernaut and it certainly appears as if this dramatic upward trend will continue indefinitely. It took Apple a mere 48 days to rise from 500 to 600 so surely it will rise to 700 in even less time.

If you wholeheartedly believed the last two sentences I wrote, please reread them. Are you being rational? Are you investing with your head or your heart?

Make no mistake, I am as bullish on Apple's stock as they come based on its dominance of numerous markets but I think some investors may be going overboard. By this point everyone has read about the bold claim that Apple will rise another fifty percent in the next twelve months to $1,001 per share and a $1 TRILLION market capitalization. I try to keep my published price targets within 25% of the current market price and revise as necessary but all anyone is asking me is whether I think Apple can hit the mythical $1,000. I am not going to go that far out on the limb but let's just say that based upon my model of Apple's earnings I have no qualms about being in the company of excellent JPMorgan (JPM) employees with a $720 twelve month target. If the iPhone 5 is as revolutionary as I expect it will be, we could see that target reached in 2012 alone. If the iTV is released this year, the sky is the limit.

I was reviewing the Apple option chain on Monday afternoon while researching my weekly covered call strategy and I was shocked to see the volume and open interest for the April 21 (Monthly) calls. With slightly less than three trading weeks remaining there are a multitude of investors betting that Apple will continue its meteoric rise. I have long been an advocate of buying longer term out-of-the-money ("OOTM") calls as a way to gain leverage in a stock that you believe will appreciate. With that information in mind, buying calls well OOTM that expire this month is probably not the most rational decision. I know that everyone has lotto fever but lets try to tone down the irrational exuberance. There is the possibility to hit a grand slam with these cheap far OOTM calls but with the significantly negative Theta, you are fighting a lose battle the majority of the time. I like to characterize my strategy as "moneyball" as I try to execute numerous small profit trades with low risk rather than swing for the fences repeatedly and risk striking out. There is nothing wrong with taking speculative positions but you need to understand the risks involved and essentially consider heavily discount the money invested.

As of Tuesday's close of $629.32 one positive standard deviation would have Apple close at $680.22. Expanding the probability to two positive standard deviations would have apple rising over $100 dollars in a mere 18 days to $729.74. As great as those numbers sound remember that the reverse standard deviations would cause Apple to fall below $600. Please consult the probability analysis from TD Ameritrade below. It is always prudent to know the odds before entering a trade so that you know at a minimum what your probability of being exercised is.

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I summarized the April 21 (Monthly) call activity below to gauge the interest in the far OOTM calls and it was quite surprising. All options highlighted in light green have open interest in excess of 10,000 contracts while dark green signifies 5,000 open contracts. All options highlighted in yellow are in the "dark zone" outside of the 95% confidence interval. It is difficult to wrap my mind around the fact that there are nearly 4,000 contracts of the 800 calls open. These far OOTM calls can be popular picks because they are cheap on a per contract basis and can surge in value in mere days; however, the opposite is true and you can lose your entire investment over the span of hours. If you decide to invest in options outside of the two standard deviation confidence I urge you to at least choose options that expire in more than forty-five days.

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My closing advice is to pick a more reasonable strike price and expiration that is at least 75 days into the future. The Apple July 21 2012 $715 Calls currently trading at $14.70 would be a reasonable choice to balance risk and reward. At this point I would wait a day to let Apple cool-down after its surge from $599 to $629

Disclosure: Author is long AAPL and JPM; short AAPL Apr 5 620 Calls.