Many of your tech-savvy coworkers have become new millionaires thanks to the meteoric rise of Apple (AAPL) stock over the last few years, or so you hear in the chat at the office water cooler, but you were always too cautious, and now, well, it looks like it is too late to make the big money in AAPL stock, even though you have seen many predictions that the stock might go to $1000 within a year or two.
Here's how you might still get on board the Apple bandwagon with this year's IRA contribution or IRS tax refund as seed money.
1. You need an IRA (or non IRA cash or margin) account that you have stocked with $5000 cash and you need authorization to trade option spreads. This is quite easy to get. You just have to fill in some forms with your online or bricks and mortar broker, sign an agreement that you may lose all your money, and then you are off to the races.
2. Now you need a serious desire to turn $5000 into $6800 (a 36% gain) or more, in less than two years.
3.You need to believe that Apple stock will at least hold its own over the next two years.
If you have not met the prerequisites, please stop here!
Right, it appears that curiosity got the better of you and you are still with me.
Step one: Look up the current price of Apple stock and then go to the options tables and identify the current at-the-money January 2014 LEAP call strike price. Let's call our strike prices S for strike. We are going to call the current at-the-money strike price S(1), for reasons which will become apparent
At the close on Friday, May 4th, 2012 S(1) looked like this:
The cost of the option shown at the ask price is $103.95 per share, which means a total of $10,395 for one option on 100 shares. "Wait a minute!" says the smart reader, " You said this trade could be put on for $5000."
OK, hold your horses, smart reader. We are not done yet.
Step two: Look up the current price of the January 2014 LEAP call that is $30 higher than the current strike price S(1). We are going to call this strike price S(1) + 30, for reasons which will also soon become apparent.
If we use the example shown above it would be the January 2014 Apple $595 strike, as shown here:
Step three: Enter an order with your broker to buy the January 2014 Apple S(1)/S(1) +30 bull call spread.
This simply means that you buy the S(1) call--which is a call at-the-money, or close to it-- and sell the S(1) + 30 call --that is the call option $30 higher--at the same time. Apologies to readers who suffer from fear of algebra, but you have already done the hard part and passed with flying colors, so bear with me.
Because entering a spread is a single transaction, you don't need the full $10,395. You only need the difference between the cost of the S(1) call and the S(1) + 30 call. This should be about $1200.
Technical notes for those who like the real nitty-gritty:
1. The 2014 at-the-money plus $30 out-of-the-money spread costs about $1200, however the exact price you can get may depend on volatility and other factors. You should be able to make an offer mid way between the bid and ask for the spread, but the exact mechanics are broker specific. If the spread is too expensive, you may want to move it one strike further out of the money.
2. Long term options (LEAPs) that are at round numbers are traded more, so are more liquid, so they are easier to trade more cheaply. The example shown in the graphic above is the $565/$595 spread, but you would almost certainly get an easier fill on the $570/$600 spread.
This S(1)/S(1) + 30 spread will cost you $1200, but if Apple stock is at or greater than S(1) + 30 on expiration, then the net value of the spread will be $3000, as you have not touched the other $3800 of your original $5000, you now have $6800 in your account or a gain of 36% on your original $5000.
Simple, yes. But, eagle-eyed SA readers will probably immediately spot a subtle flaw in this plan. Supposing APPL closed at January 2014 options expiration below strike price S(1), then you will actually lose $1200 and transform your initial $5000 into $3800, which is not at all what you had planned.
Time to introduce Plan B.
If AAPL drops another $35 from S(1), then you reset to the current stock price at S(1) - 35, which we will just call S(2) and purchase another bull call spread at the S(2) and S(2)+30 strike prices.
This will cost you approximately another $1200, but if Apple stock is at or greater than S(2) + 30 on options expiration, then your second spread will be worth $3000, as you still have not touched the $2600 of your $5000, you now have $5600 and you are still 12% ahead.
However if the stock rebounds and on expiration AAPL stock is at S(1) + 30 or above, then your return will be $3,000 + $3,000 + $2,600 = 8,600, which is a 72% gain. Not bad.
But what if APPL finished below strike price S(2)? Then you will actually lose $2400 and transform your initial $5000 into $2600, which is not what you had planned either.
Time to go to Plan C. You had to know there would be one.
If AAPL drops another $35, then the current at-the-money strike becomes S(3) to and you purchase two more bull call spread at the S(3) and S(3)+30 strike prices.
This will cost you approximately another $2400 so now you only have $200 nit deployed from your original $5000, but if the AAPL stock is at or greater than S(3) + 30 on expiration, then the 2 spreads will be worth $3000 each, as you still have not touched the last $200 of your $5000, you now have $6,200 and you are still 24%% up on your original $5,000.
Not too shabby considering that the stock may still be $40 or more below the price where it stood when you started this adventure back in May 2012.
And if the AAPL stock price recovers and gets up to the original S(1) + 30 strike price by expiration, then you are the proud owner of 4 bull call spreads worth $3000 each, which is $12,000, and your original $5000 is now $12,200 which is a profit of 144%. You should be able to live with that.
And what if the price of AAPL stock ends up lower than S(3)? Your original $5,000 has shrunk to a rather puny $200, but at least the newly-minted AAPL half-millionaires at the water cooler have changed the conversation to alimony, so $4,800 was a small price to pay.
Will AAPL go to $1000?
I have no idea. You would profit from the trade discussed here if APPL closed over $600 in January 2014.
What can go wrong if I do this trade?
You can lose $4800.
Can I close out the trade early?
Yes, you can close your position at a profit or a loss at any time and sell it for any remaining value however bull call spreads like this may not realize their full profit potential until very close to expiration.
I don't really understand about options, but this looks like a good idea. Shall I give it a shot?
Not unless you really understand what you are doing. The trade discussed is simplified a bit for publication purposes. If you understand it, you may wish to develop ideas of your own or tweaks that would improve the trade. It is best not to just copy someone else's ideas blindly unless you understand the underlying theory and principles.