Playing And Hedging Apple Into Earnings

 |  About: Apple Inc. (AAPL)
by: Mateo Blumer

Of all the noise you will hear about Apple (AAPL) going into Q3 earnings, a few simple facts stand out to me as particularly relevant to watchers of the company. First of all, in 10 out of the last 11 quarters, the stock has opened higher in the trading session following the release of earnings. Secondly, during these trading sessions, the stock has almost always hit its high for the day at the opening bell. Finally, and certainly related to the first fact, is that, over the past few years, Apple has tended to beat its revenue guidance by approximately 12-18%.

So although my bullishness on Apple is based more upon fundamental aspects of the company - such as its increasing popularity in emerging markets, sexy product line, and enviable vertical integration, to name a few - it is more for reasons other than these I am inclined to believe that Apple will yet again release earnings figures that will exceed expectations and (at least temporarily) send the stock up on the following trading day.

In many regards, Apple's (AAPL) quarterly earnings release presents an opportunity to capitalize upon the increased volatility and significant price movements that typically accompany the event - and not just for day-traders and speculators. In the weeks leading up to the release, options volatility (and thus prices) often rise considerably, creating a nice opportunity to both hedge existing positions (by writing covered-calls) or to initiate net-credit bull/bear strategies (bullish put spread or bearish call spreads).

As an example of a pre-earnings release strategy, here is a position I'm holding into the release:

Sell 1 $590 AAPL July 27 Put for $17.8

Buy 1 $580 AAPL July 27 Put for $13.15

This would give us:

Margin = $590 - 580 = 10

Net Credit = (Sold Put Premium - Bought Put Premium) = 17.8 - 13.15 = $4.65

Maximum Gain = Net Credit = $4.65 per share = $465

Maximum Loss = (Margin - Net Credit) = $5.35 per share = $535

Break Even Price = (Higher Strike - Net Credit) = 590 - 4.65 = $585.35

Return on Margin if AAPL ends up at 600 or above on July 27 = [Net Credit / (Margin - Net Credit)] = 4.65/(10 - 4.65) = 0.869 = 86.9%

I acknowledge that this is a very short-term strategy, and that it isn't for everyone. For most involved in such a strategy, it will represent only a small portion of their overall investments in the company. The strategy described above is more of a speculative volatility play attempting to take advantage of historical bias, whereas the one below is a more traditional hedging strategy applicable to more of us and with longer-term potential:

For those with existing stock positions moving into earnings, I would strongly suggest writing covered calls as a hedge, while premiums are up. If you have 1,000 shares, perhaps, I might write 5 calls against 500 shares the day before the earnings release. If the stock gaps up significantly after earnings, you could write another 5 options against the remaining 500 shares. If AAPL gaps down, on the other hand, you would simply continue to hold them as a hedge until expiration. (Though in this scenario you would probably be able to buy back your calls for a tidy short-term profit, if you are less interested in maintaining a longer-term hedge).

By engaging in such a hedging strategy, you aren't seeking to capture abnormal one-day returns by selling your shares at opening bell, and then attempting buy them back later that day or week (in many cases creating a wash sale). Rather, you are leveraging the anticipation of an event - the earnings release - to find an opportune time to open a hedge against a stock position. In many ways - especially if options premiums are high, and volume is good, as is the case with AAPL options - hedging is superior to selling.

An example of a covered-call hedge that I would do (assuming writing 1 call option against every 100 shares):

Sell 1 January 19, 2013 $600 for $54.95

If average share price is $604.3, x 100 shares = $60,430

Income generated % = (100*54.95) / (604.3*100) = 9.09%

Break even point is $549.35

Max. gain (net profit if called) = $5,065

% Return if Called = 8.39%

% Annualized Return if called = (8.39 / 5) * 365 = 611%

(click to enlarge)AAPL Covered WriteClick to enlarge

Those are the strategies I would consider pre-earnings release. Moving forward, on the day of the release, assuming Apple gaps up as I am expecting, we'll see a different opportunity to hedge, this time instead by purchasing relatively inexpensive insurance in the form of puts. I would look to purchase such protective puts at the opening bell on Wednesday, as historically this is most likely to be the time at which Apple hits its high for the day (and at which time put prices might be most depressed).

In the less probable event that the stock's rise post-release is sufficient to push call premiums above the previous day's levels, we would again see a nice opportunity to write covered-calls. If the stock gaps down post-earnings, on the other hand, it may be a good time to purchase LEAP call options on the cheap. And even for those not interested in options strategies, a post-release decline could present a solid opportunity to open or augment a stock position.

In conclusion, Apple's earnings release presents opportunities for traders, speculators, and traditional investors alike. Most of you are holders of ordinary long-stock positions, but that doesn't mean you are unable to take advantage of the historical trends and increased volatility that exhibit themselves during this event. If you own shares of Apple, don't view the earnings release as a time to sell the stock, simply because the price shoots up temporarily - especially if it is a stock that you are fundamentally bullish on and would like to continue holding. Rather, look at this event as an opportunity to open a hedged position against your stock at an opportune time. Happy hunting.

Disclosure: I am long AAPL.

Additional disclosure: In addition to owning AAPL stock, I have both long and short positions in AAPL via equity options contracts.