What Is The Right Strategy For Apple Now?

| About: Apple Inc. (AAPL)

Why not covered calls?

Few days ago I wrote an article Why Writing Covered Calls On Apple Might Be A Bad Idea. I used a methodology of CBOE S&P 500 BuyWrite Index (BXM). This buy-write strategy holds the S&P 500 index and writes a one-month near-the-money covered call on the underlying every month.

Using the 2012 data, I demonstrated that writing covered calls on a volatile stock like Apple (NASDAQ:AAPL) would significantly underperform holding the stock only.

The rolling strategy can probably be improved, but it won't change the basic fact that covered calls are much less suited for volatile stocks like AAPL.

Is it really time for a condor?

A few days later, a fellow Seeking Alpha contributor Adam Beaty suggested doing an Iron Condor on AAPL. His thesis was that the IV (Implied Volatility) of AAPL is very high and it cannot "maintain these heightened levels, so we want to be a seller of volatility here."

While I would agree in general that IV of AAPL is very high, who said that it cannot maintain these levels?

Now, before I go into some details about the suggested trade, we need to remember one thing: for every trade we take, there is someone on the other side of the trade. In order to win in the long run, we need to have an edge. As options premium sellers (and Iron Condor trade is about selling premium), we have two long term edges:

  1. The first edge is the fact that over time, options tend to be overpriced. That means that on average, the IV (Implied Volatility) is slightly higher than the HV (Historical Volatility). If you accept that, then we are in agreement that we are selling an overpriced product and over time, we should be able to make money.
  2. The second edge is our ability to control the risk and manage the trade. The risk/reward of Iron Condors is usually not good. In the suggested AAPL trade we will risk $4 to make $1. However, we are compensated by high probability of success - we probably will win 80% of the time. The trick is not to lose too much in the 20% of the cases when the trade goes wrong. The rule of thumb is not to lose more than 1.5 times on the losing trades than we make on the winning trades. So if we typically make $100 on a $500 Iron Condor, we should not lose more than $150 on the losing trades.

Where is the edge?

Now lets go back to the AAPL trade.

Do we still have the first edge on a stock like AAPL? I'm not so sure. AAPL's HV has been higher than the IV for extended periods of time. That means that you are not compensated enough for the risk you take by selling those options.

Do we still have the second edge? Again, not sure. Our ability to control the risk and to limit the losses depends on the fact that the underlying behaves "normally", meaning there are no serious gaps. If there is an opening gap, it seriously hurts our ability to control the losses. For a stock that can move $25-30 within few hours, the Iron Condor P/L will fluctuate too much.

The author also suggests using the February options for the trade. AAPL usually reports after January expiration, which means that February options are going to be very expensive. There is no reason to believe that they will be cheaper a month from now (in terms of IV) than they are today.

All this doesn't mean that the trade cannot work. The IC range of $445-660 is wide enough and if the stock remains in the current trading range of $520-580 for the next few weeks, the trade can definitely be profitable. The key is to take profits early like the author suggests and not wait till expiration. However, if the stock breaks out of the current range in the next couple of weeks, the trade will start losing money quickly. It doesn't have to trade near $445 or $660, anything near $500 or $600 in the next couple weeks - and you are looking at a significant loss. This is only $50 points from the current levels, AAPL already proved it can move that much in a matter of 2-3 days.

The point we need to remember is that high IV by itself does not mean that selling volatility is a good move. Not in case of Apple. I have no reason to believe that IV will decrease in the next few weeks.

How do we trade it now?

I recommended the Iron Condor trade to Seeking Alpha readers several times. The Iron Condor from January 10, 2012 produced a 28% gain in 2 weeks. The Iron Condor from March 5, 2012 produced a 18% gain in one week. However, AAPL is a different animal now. The AAPL that we knew does not exist anymore. It is much more dangerous and risky now, and the market doesn't know yet how to handle this new animal.

If you are a long time investor who still believes in the value of the company and doesn't care about daily or monthly fluctuations - just buy the stock and enjoy the ride. Despite growing competition and shrinking margins, the stock probably presents a good long term value at the current levels. However, if you are a trader, the only way to trade AAPL right now is with very short term options trades. This can involve:

  1. Straddles/strangles if you don't want to bet on direction;
  2. Bull credit put spreads on any pullback to the $520 area;
  3. Bear credit call spreads on any strength to the $560 area.

Any trade should include very tight stop losses and be closely followed.

Apple is reporting earnings at the end of January, and I'm going to share few ways to trade earnings with my subscribers and Seeking Alpha readers. Stay tuned.

Please trade responsibly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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