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Apple (AAPL) has experienced an extremely volatile 2012 with 5% price swings becoming the modus operandi rather than the exception. I have recommended option strategies on Apple since 2010 with positive results (remember past performance is not indicative of future results). For reference, please view the first and other articles in the series to fully understand the strategy and its strong potential returns.

This strategy is oriented towards long term investors with the objective of simultaneously generating income and reducing your effective cost basis in the underlying stock. In essence the investment objective is to capitalize on Apple's volatility by selling out-of-the-money options to generate weekly income without sacrificing long-term returns. I perform a weekly analysis of Apple's stock, options, recent news, and competitive analysis. Even if you have no plans to engage in the options market this is your one-stop primer for the critical Apple developments from the past week.

(Source: Yahoo Finance)

A brief recap of this week in Apple, which was up $21.51 (3.6%):

  • WSJ: Apple Preparing Production of iPad Mini (Wall Street Journal July 5)
  • Amazon (AMZN) Rumored To Launch Kindle Fire 2 (CNet July 5)
  • Amazon In Preliminary Stages of Smartphone Development (Bloomberg July 6)
  • Apple Cleared To Bring New iPad to China in July (Apple Insider July 6)
  • Apple Injunction Against Samsung Tablet Stands; Temporarily Stayed Against Galaxy Nexus Phone (Apple Insider July 6)

The Wall Street Journal and other major news outlets have all but confirmed the iPad Mini rumors and Apple enjoyed one of its best weeks in months as a result. Apple surged from $575 to $612 on Thursday before easing down to $605 on Friday. It is ironic that when the first serious iPad Mini reports hit the wires in April that Apple declined 10% and is still recovering from that point. Analysts are still puzzlingly debating on whether the smaller iPad will be beneficial for Apple but I still believe it will be a glowing success. My opinion on the potential success of the iPad Mini is unchanged:

"In response to a question regarding iPad cannibalization of MacBooks, then COO Tim Cook responded 'was there any cannibalization? Honestly, I don't know for sure. But yes, I think there is some cannibalization… If this is cannibalization, it feels pretty good.'…One of Apple's greatest strengths is its willingness to cannibalize its own products before competitors simply overtake them. Cannibalization has become such a vilified term in business but it generally just describes a company with the foresight to adapt before competitors do. For example, does the iPod touch cannibalize sales of the other iPods and the iPhone? Yes it does. Would it be better if Apple never released an iPod Touch and simply let a competitor release a similar product that would steal sales? Obviously no. This type of paralysis is what caused once great companies like Sony to stop innovating due to fear of cannibalizing sales of 'cash cow' products."

This sentiment continues to ring true as competitors continue to take aim at Apple's role as the leading tablet producer. For example, another week passed and we have yet another iPad competitor is on the horizon. First there was the Microsoft (MSFT) Surface, then the Google (GOOG) Nexus, now Amazon is set to return to the fray with a 4G Kindle Fire. The iPad Mini is well poised to counter any momentum generated by new low cost tablets from the likes of Google or Amazon. The rumored smaller iPad will likely be ready for the holiday season along with the New iPhone and Apple will have a completely dominant position for the fourth calendar quarter of 2012.

There has been chatter that iPhone sales will be light when Apple reports earnings on July 24 but that would not be entirely unexpected. Consumers typically start delaying purchases of iPhones ahead of new iPhone launches and the pent-up demand is simply deferred to the subsequent quarter. I am still adamant that Apple is a great buy under $600 and any dips are attractive opportunities for long-term investors. It is not unfathomable to envision a scenario in which Apple declines immediately after the earnings release; however, the conference call is always optimistic and everyone knows that Apple has a strong second half in store. Notice that I have not even mentioned the potential game-changing new iTV that is likely to be announced in the next twelve months (it is debatable whether the TV will be ready in 2012). Overall you need to stay long Apple and not be overly concerned by any declines. I would avoid going long with short-term calls this week after the 3% rise last week.

Below I present three possible scenarios and the potential returns for the Apple options. The first scenario represents a negative outlook for Apple while the final two scenarios are more reasonable. These scenarios are forecasts and there is no guarantee that they will come to fruition. Even if you are optimistic it is important to consider both positive and negative circumstances in order to stress your assumptions. As a general rule, selling calls with higher strike prices has greater potential return but additional risk of loss due to the lower (or lack of) downside protection. For more information on the fundamentals of covered calls, consult Investopedia.

Additionally, if you would like even more information, I have prepared a sensitivity analysis for absolute return and percent returns, respectively. After studying the information above, these two charts make it easy to pick a strike price based on where you believe Apple will close at the end of the week. Estimate where you believe Apple will close and select the strike price with the highest return.

With this information, executing a buy-write on AAPL July 13 (Weekly) 615s is the optimal risk-return strategy as an opening Apple transaction. If you are uncomfortable with this strike I would consider a buy-write in the range of 600-625. Even if you are extremely bullish you can still profitably sell covered calls. Apple is volatile enough that you will have opportunities to repurchase on further dips. An alternative approach is to sell out-of-the-money 600 puts and collect the premium without having to purchase the stock outright. Based upon Apple's volatility I think this might be the best strategy of all for this week. Note that if the stock declines to the strike price, you are obligated to buy the stock (or close out the position). You should always consider the risk factors (particularly with naked calls or puts) raised in this article in light of your personal circumstances (including financial and taxation issues) in consultation with your professional financial adviser.

Disclosure: Author is long AAPL and GOOG; plans to write July 13 AAPL $620 Calls.

Source: Will The iPad Mini Be Good For Apple?

Additional disclosure: Author is long AAPL and GOOG; plans to write July 13 AAPL $620 Calls.