Those who cannot remember the past are condemned to repeat it. -- George Santayana, in his Reason in Common Sense.
Apple (AAPL) has had a meteoric rise to over $630, and with earnings approaching later this month, the chatter is increasing. Will it hit $700, $1,000 or even more? Before I get carried away in all the euphoria, I am first reminded of another stock with a remarkably similar pattern: Potash of Saskatchewan (POT).
In late 2007 POT was the market "sweetheart" and was trading around $40, and within a year it was at $250. Analysts couldn't raise their forecasts fast enough, and were predicting $350 within a year. Well, we all remember 2008. In just a matter of a few months POT crashed 75% to $60. It has managed to work its way up but now is still 50% off its high.
The market rewards good behavior (prudence) and punishes bad behavior (greed). So, regardless of how I feel about AAPL, it's time to replace some euphoria with prudence. I took a very large position in AAPL and its recent run-up has distorted my asset allocation. So, I'm going to start hedging part of my long exposure. My goal is to bring my asset allocation back into balance by reducing some of the AAPL-specific risk. I remain bullish and expect a continued uptrend for AAPL, it's just that I want to consider two possibilities:
1) The Black Swan event, either market-driven or AAPL-specific. Because I am bullish on AAPL, I'm not so worried about volatility as I am about either an economic or geo-political upheaval.
2) The possibility that AAPL "cools off" a little, but remains attractive.
A particular problem with hedging AAPL is that one option represents 100 shares (representing $63,300 in AAPL). This makes conventional hedging techniques almost impossible unless you own several hundred shares. For the most part, AAPL shareholders with more modest holdings have been afforded no real opportunities to hedge these positions.
But, there is a path that can offer both the larger and more modest shareholders good upside and protect, not against every decline, but at least, the "Black Swan" event.
There is an unorthodox approach that works with a holding of as little as 25 shares of AAPL. The goal is to have as much upside as is consistent with guarding against extreme downside risk.
The plan is pretty simple: Replace AAPL stock by hedging with a Bull-Put Spread for four times as many shares. I call it the 4X Bull-Spread.
So, looking to hedge 100 shares:
1) Sell 100 shares of AAPL
2) Sell FOUR January 2013 In-The-Money puts with a strike of $640. This credits $ 32,096 ($80.24 per option)
3) Buy FOUR January 2013 protective puts with a strike of $585 for a debit of $21,492 ($53.73 per option)
This results in a net option credit of $10,604.
If as few as 25 shares of AAPL were to be hedged, then the strategy would be the same, just the 4X Bull-Put spread would be for one option, instead of four options, and so on.
The table following shows the profit/loss of the Bull-Put Spread assuming four options .
Current Price: $633.68
Four Bull-Put Spread $640/$585 Strikes
|Price||Profit / Loss|
As can be seen the maximum profit of $10,604 is reached at AAPL=$640. AAPL can actually fall to $613 without loss. The maximum loss is $11,396 at AAPL= $585.
The question, now, is: How does this compare with owning 100 shares of AAPL outright?
Well, in order to make $10,604 owning 100 shares, the stock would have to climb $106 to $740 by January 2013. Not impossible, but it takes a pretty good upward move before owning 100 shares out-performs the 4X Bull-spread.
In actual operation, the upside to the 4X could be enhanced. For instance, if AAPL climbed to, say $700, it would be low risk to sell the $585 protective put prior to expiry and capture whatever residual value it held.
Also, keep in mind, AAPL need only reach $640 for this Bull-Spread to make its full profit and that represents a distinct advantage if AAPL doesn't crash, but instead sees more modest growth. This satisfies the concern that AAPL may experience a less robust share price appreciation.
What if AAPL crashes? The maximum loss is capped at $11,396 on a fall to $585. Owning 100 shares would have lost only $4,800 at AAPL= $585, so there is some more downside risk on this spread at that level.
But the Black Swan event and the maximum 4X loss is capped at about $11,000, whereas the stock has $63,000 exposed, so, the downside risk is capped at about 17%.
In short, this strategy 1) allows for considerable upside to AAPL, 2) bigger gains on a more modest up move, 3) gains even on a mild down move and 4) limits risk in the event of a "Black Swan." This meets the stated criteria.
This example is just that -- an example -- and is not intended to be all-inclusive. There are many variations that can be employed that can re-align the upside and downside risks. The ITM put could be sold at a higher strike, the protective put could be set at a lower strike, the expiry dates could be varied, the 4X Bull-Spread could be converted to a 4X Bull-Calendar Spread or the ratio could be changed from 4X to 3x, 5X and so on.
In choosing this particular option spread, the objective was to gain the equivalent of a $100 up move in AAPL. Holding 100 shares that means a target profit of $10,000 on an up move. Next, was limiting losses in a Black Swan to the same $10,000.
If one wanted more profit and was willing to take on more risk, a 6X Bull-Put spread will increase the profit/loss potential to $16,000. Compared to owning 100 AAPL shares means that AAPL's share price would need to climb to $800 to best the 6X Bull-Spread. But, the 6X makes this gain at AAPL=$640. The downside risk limit would still be capped, and correspond to a drop in share ownership of about 25%. It's always a balancing act of prudence vs. greed.
Selling puts near the money captures as much extrinsic as reasonable and this led to the $640 strike. The $585 strike was chosen to limit the downside to $10,000. This same technique could be employed for different target gains/losses and other stocks, as well.
One housekeeping matter. The margin requirement is only around $11,200 for the four options and actually provides more margin flexibility and buying power than owning 100 shares for $63,000.
Conclusion: I remain Bullish on AAPL. Since I'm only hedging part of my position at this juncture, I hope the switch to 4X ends up costing me gains I would have otherwise made. The 4X strategy is my nod to prudence. Instead of taking some AAPL completely off the table I'll just put an option driven stop-loss under those shares.
When we feel more comfortable with our risk exposure, reason takes over from emotion, and we will be better able to judge and manage the remaining position.
An AAPL share price of $1,000 isn't out of the question. This article isn't about "wishin' and hopin,'" it's about investing discipline and managing risk. No one knows when it's the right time to hedge any stock. But with every stock, that time will come. What I do absolutely know is that I must be in front of the event, not behind it. The 4X strategy is one way of accomplishing this, and is particularly relevant for those with more modest holdings in AAPL.