There is no doubt that Apple (AAPL) had a remarkable run in the last three months. It reached another all time high Thursday at $633.
Some people would argue that it's gone up too far too fast. Others say this is only the beginning, based on the fact that the stock is still cheap. Maybe you fall somewhere in between. You think that the company is going to have another blowout quarter and the stock will easily go up another 10% after earnings. But you are also cautions and realize that any mistake or earnings miss might cause a selloff.
You want to have your cake and eat it too. You want to participate if you are right about the upcoming quarter but you also want to have some margin of safety. You don't mind owning the stock if it dips below $600.
There is an options strategy which allows you to achieve exactly that. It is called Risk Reversal. You are selling an OTM (Out Of The Money) put and using the proceeds to buy OTM call. In the case of Apple:
- Sell AAPL May 600 put
- Buy AAPL May 670 call
The trade can be done with zero upfront capital - the credit from the put sale pays for the call purchase.
The P/L at expiration looks like this:
The P/L graph at April 25 (the day after the earnings announcement) looks even more appealing (assuming you are right about the blowout quarter):
Advantages of Risk Reversals:
- You have a stock-like position with a fraction of the capital required.
- If the stock moves in your favor, your return on margin is much higher than just owning the stock.
- If the stock moves against you but stays above $600 at expiration, you lose nothing.
Disadvantages of Risk Reversals:
- Leverage works both ways, so your loss will be higher as well if the stock moves against you (percentage wise).
- The trade still requires hefty margin (about $10k in this case).
- There still is unlimited downside risk so you need to manage risk accordingly.
Please note: this is trade analysis, not a recommendation. Make sure you understand what you are doing before taking any trading decisions.