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This is a reply to John Mylant's thought provoking Seeking Alpha article entitled An Options Trade For Apple (AAPL). You are recommended to read his whole article, but the suggested trade quoted below is the meat and bones of it, reproduced here with only slight edits for clarity.

Situation: Apple last traded at 533.62.

Actions:

  • Sell a 590 strike Call option with a May 25th expiration (priced at $0.47)
  • Buy a 600 strike Call option with a May 25th expiration (priced at $0.27)

Outcome:

Net Credit to start: $0.20 or 2.0%

Reasoning behind the Trade:

  • Apple is in a bearish trend with no sign of turning around.
  • I will buy and sell the call options since they lose value while the stock moves down.
  • I am 57 points out from the trading point of the stock at this point.
  • I don't expect Apple to suddenly gain 11% in value in one week with the markets as bearish as they are.

At first glance this trade doesn't look quite right to me.

You sell the spread for 20 cents, but this would have to have been done on Friday between the article being posted around 3 p.m. and the close of business for options at 4:15 p.m., otherwise value of the spread would decay considerably over the weekend.

If you did it at the level of 1 option for 100 shares, netting $20, any profit would be swallowed by transaction costs, but let's say to make it worthwhile we put on 10 contracts, so then we are potentially on the hook for $9,800 of losses to make a profit of $200, which would be realized in the event of the options in the spread expiring worthless a week later with the stock price less than $690.

Not very likely that this will happen, agreed, but the trade might work better as a hedge if you already have a sizeable long position in AAPL of which the profits will overwhelm any losses from this trade.

For example, if the trade went bad and you had 100 shares of AAPL, then you would gain about $7,000 on the stock to offset your loss of $9800 on the options trade.

Of course risk management is necessary on any options trade, and you would want to place stop loss orders to buy back the spread if it doubled in value, and the original proposal might have gone into more detail on setting stops, doubling down, etc.

Let's think a bit about how that would work. If the stock gained about $20 from its price at the close on Friday to when it opened on Monday morning, the initial short position, in spite of time decay, would almost certainly more than double from $200 to $400 and one might want to get out at this point, since clearly the thesis that AAPL is in a bearish trend with no signs of turning has been called into question by some event , global or otherwise, affecting demand for the stock.

Bottom line, is it worth putting 10,000 on the line to make $200 in a week? For a single trade probably no, but if done regularly, how would that work out?

You could make $800 per month, or $10,000 per year (100%) if the trade is put on each week--though with APPL, you would want to stay away from the trade in the weeks around earnings releases or new product releases. When you look at a trade in terms of an annual return of 100%, it starts to look less like an ugly duckling and more like a very fine swan indeed.

(click to enlarge)

Of course the more times you go to the well, the greater the likelihood of falling in. Do you go for 20 cents fifty times, or just try to go for a buck fifty seven times?

How would you do that?

Well, if you really were convinced the outlook was poor for AAPL, you could have put on the weekly $550/$560 bear call spread for a credit of about $1.40.

(click to enlarge)

WIth ten thousand dollars at stake, you have a shot at getting back $1400 in a week, which sounds tempting, except that if the stock opens at $550 on Monday morning, you are probably already up to your knees, $3500 into the hole and staring into the $10,000 abyss. Yikes! I'm an investor, get me out of here!

Could this happen? Probability says most likely not, but then again a sudden announcement that Greece had invented democracy, or that Spain had finally located El Dorado, or that Italy had struck oil in the Venetian Lagoon, or that the Irish had rediscovered their luck, might just give the whole market a kick up the bottom nice boost.

Returning to the original trade: Risking a possible $10,000 to return $200 per week is not to everyone's taste, and the idea will shock some conservative investors, but then again it is a potentially high rate of return on a relatively modest block of capital that might find a place in some portfolios.

Because APPL has a high stock price and a high level of volatility, its options are relatively expensive, there are a vast number option strike prices, and value extends a long way out of the money. This makes AAPL a much better candidate for this type of trade, than for example, lower priced stocks such as Microsoft Corporation (MSFT), Intel (INTC), or Walmart (WMT).

The pricing of options is really determined by the price of puts, which can be described as price of buying insurance on the stock you already own. Because the price of calls is inextricably linked to the price of puts due to the phenomenon of put/call parity which ensures that the price of long puts is similar to the price of short calls, there may be times when calls that are far out of the money may be overvalued relative to the risk that is entailed, and this may be one of them.

For that reason I suspect that John Mylant's ugly duckling will grow into a fine swan--at least for this week. We will soon see.

Source: An Options Trade For Apple: But Is It An Ugly Duckling Or A Black Swan?

Additional disclosure: I am not a professional investment adviser and the content of this article is intended for discussion purposes only.