A number of articles are being written about making money with options in connection with the ownership of Apple (NASDAQ:AAPL) stock. However, as our old pappy used to say, "It's not what you make, it's what you keep." Investors who own Apple (or any other high quality stock) should also be attuned to market conditions that periodically signal caution in order to preserve capital, keeping in mind that the No. 1 rule of investing is "don't lose money."
Managing investment positions is an ongoing, time-intensive process; it is much more about making adjustments to preserve and protect capital than it is about predicting or timing the next major market move. Generally, the times that investors should consider defensive measures for stock positions include imminent earnings releases, increases in volatility, and general market risk. These conditions are currently present in Apple.
Nearly a year ago we wrote an article demonstrating one of several techniques for protecting Apple stock ownership from general market risk for a full three months. The trade was not without some risk itself, but the risk was that you might end up owning more Apple stock at a much lower price. This would have been a nice problem to have -- and there are no risk-free trades.
As it turned out, all of the options expired worthless (pretty boring) and the scenario actually made a buck or so for our effort. But boring is good. We believe that this is the way to trade and invest using options. We use them as tools for protecting and increasing quality equity positions, and as a method for extracting additional "income" from the sale of option premium.
So what's different about Apple today compared to when we published our article on June 24, 2011, aside from the difference in the stock price? At least three things: 1) earnings are imminent, 2) increased price volatility, and 3) increased option implied volatility. How can we protect our equity and take advantage of these conditions?
Option straddles and strangles attempt to take advantage of price movement accompanying earnings, but do little or nothing to protect equity positions. Selling covered calls or cash secured puts afford some equity protection, but not comprehensively, and option collars usually cost money. We like to get paid to trade.
Note that there are numerous ways to use options. You are only limited by your imagination, yet we recommend that before structuring an option trade an investor should first identify market conditions and the objective(s) sought before a plan is undertaken to address those conditions.
Without going into the technical analysis that accompanies our trading plans, here's what we would do ahead of the Apple earnings announcement:
- Sell June 640 calls at 14.00 to cover the equity position;
- Buy May 570 puts at 28.00 to cover the equity position;
- Sell 2 August 460 puts at 12.00 each for every May put you purchase.
This trade is done at a 10.00 credit, so you get paid to protect your position in advance of the earnings release. You'll note straightaway that it will likely be necessary to make adjustments to the position depending upon the happening of various potential scenarios. There are no option positions that you can initiate and simply ignore.
We would suggest that in the event the Apple stock price moves upward in response to earnings that the May puts be sold within days of the news release. Assuming an upward spike in price whereby you sell the May 570 puts shortly after a "favorable" earnings announcement, the cost of the May put is probably then completely covered (and more) by the August cash covered put sales. On the other hand, if the price of Apple continues downward, holding the May 570 puts would be prudent in order to protect against further price erosion in the stock.
The price of Apple would have to exceed at least $654.00 ($640.00 + $14.00) by mid-June before you should permit your equity to be called away by virtue of the covered calls. In the event the price of Apple climbs slowly after earnings, it may be that you can still buy back the covered calls at a nice profit. However, that is the risk of selling covered calls here. If Apple reaches and maintains new highs by or before mid-June and you do nothing with the calls, your equity will be called away -- but at $640.00 per share. If Apple is trading at $440.00 in six months, is $640.00 a reasonable exit point?
You'll note that the expiration months for the various options we have selected are staggered. Generally, they have been selected based upon the following factors: 1) the May expiration for put purchase was selected due to the imminence of earnings, and in relation to the presently high level of option implied volatility; 2) the June expiration and strike price for the covered call was selected due to recent chart action and the increase in option implied volatility, giving us clues about the probability that the price of Apple will (or will not) exceed $640.00 by option expiration; and 3) the August expiration for the cash covered put was selected due to the probability that the price of Apple will (or will not) drop below $460.00 by option expiration.
Of course, each trader/investor will see these probabilities differently; and that is what makes for differences in trading styles, risk tolerance, etc. But there is no doubt that the skillful use of options adds protection and flexibility to any trading program.