Allocating Trade Capital To Apple's iPhone 5 Announcement

| About: Apple Inc. (AAPL)

Similar to researching ROIC for a fundamentally long position, ROIC is important to utilize in a trading context. Options allow you to attain a more favorable ROIC than being long shares. We can apply this principle to the coming weeks for Apple Inc. (NASDAQ:AAPL). I believe we will see a further run up in AAPL shares ahead of the iPhone announcement than we have seen the last few weeks. Sentiment has historically improved ahead of similar announcements. The chart below shows how the P/E multiple expanded weeks before the June 2007 announcement, which accompanied a higher share price.

Click to enlarge

If you agree that AAPL sentiment will improve and the price will be higher than it is today in one month, then I present to you a trade that optimizes your allocated capital. It addresses how to structure a synthetic long AAPL position with the same downside dollar risk. I am suggesting that in place of going long the shares that a credit put spread is a good option to tilt the upside in your favor. The suggested legs are short the September 630 strike and long the 625 which maximizes your ROIC better than short 630 and long 620. This also mitigates some additional downside risk.

The trade requires us to do a little bit of background research to analyze the downside risk in AAPL shares as the strategy is predicated upon return on risk. The steps to research are as follows:

  • Determine a downside price target through mid-September. The upside is not as important to forecast as the option trade is neutral/long bias.
  • Use the downside risk to determine the number of spreads to sell.
  • Review the calendar until September expiration to understand the potential downside risks.

Downside Valuation

For this strategy the downside is most relevant to forecast as it determines the number of spread contracts to sell. I have utilized P/E and P/B to forecast my downside in a worst case scenario. Reviewing the history of these trailing ratios provides a best guess of the downside during similar announcements of the iPad and iPhone. When reviewing P/E and P/B for AAPL, the lowest trailing twelve month values we've seen in the past two years would price AAPL at approximately $500. I believe this is an extremely conservative estimate and warrants a higher downside price. I am still conservative so believe a $550 downside is possible in the worst case. I tend to price in the worst case scenario on the downside and a base case on the upside. This better manages my expectations as I am reviewing risk by not overestimating gains and underestimating losses. Trailing EPS and book value multiples are applicable since Apple will report its next earnings in October after expiration, thus they will not change during the contract.

Return On Invested Capital

I am recommending a put spread trade for the benefits it offers on the upside, or even if the stock remains neutral. Going long the stock will require a significant percentage return to outpace the return on risk achieved on the spread trade even if AAPL stays around where it is currently. The key to the trade is calculating the number of spreads to sell to optimize your percentage returns and take on similar risk to being long shares. Here is how to do so. First, we must quantify the max losses for the spread and a hypothetical 100 share long position. The max loss on each spread is $300 while the downside on the each share of stock is $80, or $8,000 for 100 shares. The number of contracts to trade is determined by taking your max stock loss and dividing it by the max spread loss (8000/300) - approximately 26 spreads. This way, if AAPL were to fall below where it is today you are allocating spreads in a similar manner to the dollar downside risk of being long the stock.

Here is where the true benefits of the trade are apparent. The ROIC for the spread trade is 66% compared to that of 8% for the long stock position, assuming a $680 upside target. Worth noting, I equate invested capital for the spread as the max loss whereas invested capital for the long share position is the cost of the shares. This trade maximizes the use of capital and tilts the upside in your favor as the stock must only close above $630 in the next month to make it a more efficient trade. To achieve a 66% ROIC for the long shares trade, AAPL would have to be priced at $1050 by September expiration - an unlikely event.

In all likelihood, AAPL will be higher than where it is today come September and below $1050. If you agree with my forecasts, then the optimal allocation of your risk/capital is suited well to the spread trade. I have included a spreadsheet below to demonstrate my calculations.

Risks and Other Short Term Uncertainties

Seeing that the ROIC potential for this trade is far higher than the long potential, there must be some sort of additional risk that accompanies the reward. One of the most interesting parts about the market is the interaction of risk versus reward and it is indeed present in this trade. The heightened risk of the put spread is that there is a 100% loss if AAPL closes below $625 at expiration. Conversely, you would only lose a few 100 basis points if long the stock. This must certainly be considered and does represent a risk that is working against you. I would also suggest looking at the fact that the max ROIC is reached at any price above $630 at expiration. Being long the stock would only earn you a small ROIC if the price is slightly north of $630.

There are additional risks which I view as more directional factors. The timing of the iPhone 5 announcement could affect the trade as expiration is 10 prior to expiration. The announcement could not have the excitement of other releases. Further, we have to remember that it is just speculation the new iPhone will be discussed during the presentation. These factors would likely have an adverse effect on the share price and result in 100% loss. You could even mitigate some of that risk by selling the 610 and long the 605 strike (30% ROIC), thus giving yourself some more breathing room.

Not so much a risk but worth reviewing is that the ROIC I discussed doesn't mean you are making more dollars in absolute terms. The percentage return on your invested capital is much greater, but the dollar return is less compared to owning the shares outright. This strategy is best suited for a trader who does not want to allocate $63k in capital to owning 100 shares and would rather maximize the ROIC with similar downside risk characteristics. This strategy is certainly not an all in approach due to the loss potential.

(Prices are as of 8/16/12)

Disclosure: I am long AAPL.