Apple: Trading The Calendar For The Next Few Months

Aug. 3.12 | About: Apple Inc. (AAPL)

As I have covered in previous articles of mine, I am comfortable relying on the fact that Apple Inc. (NASDAQ:AAPL) has a limited amount of downside and the risk/reward is heavily skewed in the investor's favor. This opens up a tremendous number of trading opportunities for anyone that can be patient for 6 months to a year. I believe there is a good opportunity to utilize options to achieve a return on capital that is not possible by purchasing the stock outright. Similar to how I rely upon relative ratios for many of my strategies, I have assumed some conservative estimates using P/E as a guide.

The AAPL Calendar

It is widely known at this point that AAPL will likely show off the new version of its iPhone on September 12th. This news is currently priced into the stock as it has rallied nicely the last few days. This leaves opportunities for AAPL to be range bound until late September, as no other major news is slated to be released. Also worth noting, is AAPL tends to trade up a few weeks ahead of earnings and may do so throughout October when 4Q earnings are reported - after September option expiration.

The next few events will be focused on earnings which will be reported in October and January, encompassing the holiday sales season. Intermittently, I wouldn't be surprised to hear a few notes about unit sales guidance and unit shipments upon product release, or even news of an iPad mini.

Altogether, the calendar shows us that AAPL will be somewhat range bound up until October when earnings are reported, and then rally more ahead of holiday earnings. This is very important to the success of my strategy.

Financing a Long Call Option

Everyone has different names for spreads and other multi-legged option trades. Whatever strategy it be, many times it can simply be boiled down to financing a directional trade. My strategy is just a cheaper way to go long AAPL through January 2011. I am suggesting a 2 to1 ratio/calendar spread selling the September 525 put/September 690 call while going long a January 610 call. The trade will go heavy on the short options expiring in September. This affords me the ability to reduce my capital risk while gaining a delta advantage by being better able to purchase at the money for a reduced price.

Now, you'll recall I mentioned an efficient use of capital. This strategy has a potential return on capital of 41% versus an outright purchase of stock at 9%. I am assuming a January price target of $662, which will be 14.5x TTM EPS at that time. This is a very realistic price target as the stock has averaged 14.5x P/E for the past year, and there is not much of a reason to anticipate a significant multiple expansion or contraction at this point. If you are concerned, I'd suggest reviewing my recent article "Apple: A Wide Moat." It's worth noting that the short strike prices I've chosen are based upon the minimum and maximum P/E over the past year as well. It is likely that the next month will not elicit a drastic change in either direction for P/E.

Potential Outcomes

I am very comfortable with the fact that AAPL will not trade at either 12x or 16x EPS (the chosen short strike price targets) in the next month as it has not touched those levels in the last year. This will make the heavier weighted short strangle position profitable and increase the likelihood (or decrease the loss potential) for the long call position. I view this as a very favorable outcome. The best case scenario is that AAPL trades range bound similarly to how it has been doing recently with the gains made in the latter part of the year. My price target of $662 would leave me with a $15 profit on a strategy that costs $37.41 per share to undertake. Please see the below table for my calculations.

The worse case scenario would be that AAPL rallies above $690 before September expiration, leaving me to exercise my call/let the put expire and be short 100 shares which I would immediately close out. Conversely, a bear scenario would leave me with more shares than I planned. I don't view this as a hazard, though, as I'd be happy to purchase more shares at $525. The short-term upside issue is mitigated by the fact that AAPL typically exhibits a size risk, wherein superior financial performance is discounted.

Option Strike Contracts Cost Total Cost
Sept Put 525 2 2.34 4.68
Sept Call 690 2 2.13 4.26
Jan Call 610 1 46.35 46.35
Cost (37.41)
AAPL Breakeven 647.41
Jan Target 662.00
Intrinsic Value 15.24
Option ROIC 40.7%
Outright Purchase ROIC 8.6%
Click to enlarge

No Trade is Without Its Risks

Now, with the 41% potential ROIC, there are certainly some downfalls that must be vetted before enacting this trade. This trade is only profitable in January if AAPL is trading north of $647 with a potential loss of 100% if below $610, not accounting for the premium received. It can be easily argued that the downside in the stock is not 100%, or even 20% for that matter, so I don't believe the short put option is much of a risk.

The positive part is the timing of the short and long legs. AAPL has a tendency to report unit sales on new products just after product release which is after the short leg expires. The volatility can then ensue once the trade has transitioned to a long bet. AAPL can then report earnings and provide numbers for holiday unit sales, thus likely sending the shares higher.

Altogether, AAPL is not that volatile a stock when reviewed percentage-wise. Yes, the dollar value swings wildly, but the annualized volatility is circa 7% which is much lower than the acceptable volatility of many hedge funds. It is probable AAPL will trend up consistently in the next months and the low volatility will play well into this trade. Let's talk in January and see if I am correct.

Disclosure: I am long AAPL.