Last week I wrote an article that described how to buy cheap bull call option spreads in Apple (NASDAQ:AAPL) so that you could win if the stock went up in value, and have a great chance to win even more if the stock went down in value. The play involved buying one spread, and then a second spread if the stock went down, and then two more spreads if it went down even more.
This is not the same as doubling down, because we used the numbers in the series 1,1, 2 which are part of the Fibonacci number series in which the third number is always the sum of the preceding two numbers.
Another system that roulette players like to use is called the Martingale system and it is a double down system, so the number series goes 1,2,4,8 and so on.
In theory this system should work well on an even chance like odd or even as no matter how many successive times an odd number comes up, it is certain that an even number will show up eventually.
In practice it doesn't work so well because an odd number could come up many times in succession and wipe out the roulette player, or he may reach the maximum table bet in which case he will drop a bundle.
Nevertheless this system can work quite well for buying ordinary stock.
Stocks tend to operate on a binary system. Either they go up or they do down. So the idea is that if we invest and the stock goes up, we make a profit, and if we invest and the stock goes down, we double down using the Martingale system, otherwise known as "buying on the dips."
Let's see how this would work out with an example. Let us suppose that Apple's share price is at around $600 and we think this represents reasonable value. In fact we have read many articles on Seeking Alpha suggesting this stock is too cheap. We'll say that we have a maximum of $5000 to put into this position since this is the limit for an annual IRA contribution.
STEP ONE
We buy one share for $600. If the stock goes to $630, we have made a nice 5% profit, but if the stock falls to $565, let's apply the Martingale system and buy 2 more shares.
STEP TWO
Buy 2 more shares at $565 each. Now we have 3 shares at an average basis price of $576.66.
If the stock goes back up to $630 we are showing a profit of $160, which is 9% on the $1730 we have committed so far. At this point we need the shares to get to $576.66 to break even. But if the stock falls another $35 to $530, let's apply the next Martingale number.
STEP THREE.
Buy 4 more shares for $530 each. Now we own 7 shares at an average basis of exactly $550 each (now you know why we started at $600 even), so we need the stock to go up to $550 to break even, and if the stock goes to $630 then we have a profit on the books of $630 minus 550 times 7, which is $560 or 14.5% over our total investment of $3850. Well done us!
Now lets compare this with the options trade we examined in the previous article.
The bull call spread options play involved buying one spread, and then a second spread if the stock went down, and then two more spreads if it went down even more and used Fibonacci numbers instead of Martingale, but the effects are similar and in both cases we bought more stock or more options if the stock fell $35 from our Starting Price, which we will now call S.
Definition: Let the price of the stock when we started our trade in each strategy be known as S
With both trades we reached our maximum investment when the stock fell $70 below S.
Using the options trade with the Fibonacci numbers we made break even when stock was $46 below S. With just the 7 shares of stock and the Martingale numbers we make break even when the stock is $50 below S.
With the options trade we reached our maximum profit level with the stock at $630. Our maximum profit was $7200. With the stock trade there is no maximum upside. However to equal the profit made by the options trade at $30 above S , the stock would have to go to $945 per share above S, which seem unlikely (unless APPL merges with AMZN to acquire its P/E ratio!).
With the options spread trade the most we could lose was $4800 with the stock at $70 below S at January 2014 options expiration. With the stock trade, if the stock was at $70 below S, we would only have lost $20 per share or $140 and would not lose all our money unless AAPL went bankrupt (very low probability).
With the options trade if the stock finished $30 above S after dipping two times , our profit was $7200. With the stock trade, if the stock finished $30 above S after dipping two times our profit was $560.
With the options trade if the stock went straight up and never pulled back to $30 below S, our maximum profit on our $5000 stake was $1800 or 36%.
With the stock trade if the stock went straight up and never fell back, our maximum profit is unlimited, but to make $1,800 profit on one share in the same time frame, the share would have to go to $2,400 by January 2014(very low probability).
Summary
Comparison of APPL $5,000 options spread trade vs APPL $5,000 stock trade
Options spread trade | Stock trade | |
Break even point | $46 below S | $50 below S |
Maximum loss | $4,800 | $3,850 if stock goes to zero |
Maximum profit | $7,200 | Theoretically unlimited, but with AAPL at $1000, the maximum profit would be $3150 |
Stock price needed for maximum profit | $30 higher than S | $800 higher than S to equal potential profit of options trade. |
Both trades have their pluses and minuses. The biggest difference is that with the options trade your entire $5000 stake is at risk if the stock drops $70 per share by January 2014, whereas with the stock purchase, the likelihood of losing all is about zero.
On the other hand, the options trade will pay off much, much more at a much lower level if the stock moves into positive territory by January 2014.
The real thing to remember here, though, is that the future value of AAPL stock is not a completely random event like the spin of a roulette wheel.
You have to make your own calculations as to whether the odds are in favor of AAPL increasing profits and/or expanding its P/E ratio or not within the time frame of now until January 2014.
You pays your money, and you makes your choice.
Disclosure: I am long AAPL.