Apple Shares Currently Have Greater Downside Risk Than Upside Potential

| About: Apple Inc. (AAPL)
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So, you hold Apple (NASDAQ:AAPL) stock. But what you want to know is whether you should continue to hold, or sell. After seeing such a rise in the share price as we have over the past few weeks, I'd want to know the same thing. And the truth is that no one will be able to tell you with any certainty. If you sell now, for sure you'll have banked a healthy profit. But if the share price rises another 10%, then you might be kicking yourself. Similarly, if the company were to announce a massive single special dividend, selling now would mean you miss that.
But how about putting a trade on that will protect you against a fall in the market, whilst also taking advantage of a further rise toward $600 and keeping the option of receiving the dividend (should one be announced)?

Before we look at the trade itself, it might be worth figuring out just why the share price has risen so dramatically.

Without a doubt, consumers have been smitten by the tablet and smartphone technology. Apple has the world-leading product in both categories.

Its fourth quarter results last October disappointed as it missed revenue targets. The reason? Consumers were thought to be waiting for the next generation of its iPhone, which at that time constituted 40% of its annual sale. Its new generation iPhone, 4S, has subsequently been released and was the main driver behind record quarterly profits of over $8 billion announced last month.

Apple's iPad tablet is outselling rivals across the world. Currently at iPad 2 stage, its sales have been another focus for results-oriented investors, and iPad 3 is just around the corner, which looks likely to be accompanied by a lower cost version of the iPad 2.

Apple has also been adding new resources to its product offering. It has launched iBook for authors, perhaps as competition for Amazon's (NASDAQ:AMZN) author publishing options, and it is also making inroads into the education arena.

First quarter sales surged by 73% from a year earlier, which helped profits double, and there seems to be no stopping the company.

All this, and more, has added up to a current share price of around $545 and a price to earnings ratio of 15.50. With earnings expected to rise to around $43 for the full year 2012, the forward price to earnings ratio of 11.47 could be considered undemanding. So, is there any cause for reticence when considering whether to hold or sell?

A further key driver of the share price rise has been the vast cash pile that the company has (around $100 billion). There has been much speculation about what the company may do with its cash, but such speculation centers around two options.

The first of these is to make acquisitions to further its business. Whilst an acquisition may be good for the company, depending upon the synergies and fit, if Apple makes a move on another company I am convinced that it would be forced to pay top dollar, and then some. Apple is the gorilla in the market place, awash with cash and any management worth its position would demand as much of Apple's cash as possible. In order to make such an acquisition, Apple would be forced to part with a large premium for its target. Such a payment could make the acquisition less attractive and put some pressure on the share price, at least in the short to medium term.

The second option, seemingly gaining favor, is for Apple to make a special one-off dividend payment. Its cash pile is increasing by around $10 billion each quarter, give or take. Its market capitalization, at a little over $500 billion, is five times its cash balance.

Shares have, without a doubt, been increasing in price partly as a result of rumors of what the company will do with its cash. Were it to pay a one-off dividend of, say, $25 billion to its shareholders, the company would have $75 billion remaining. It follows that a minimum of $25 billion would be wiped from its capitalization, and, possibly, as much as $125 billion, were the market to value that cash in the way it does now. Paying a special dividend from exisiting cash would also leave the company less ability to make opportune acquisitions.
Realistically, I feel that the market capitalization of the company would drop by some amount in between these two figures were the company to pay a special dividend, but possibly by three times the cash value of the dividend. On a special dividend payment of $25 billion, that would lead me to expect the share price to fall to around $475.

Analysts have a median target for the share of $570.

So how to protect against a fall in the share price due to a one of dividend - that you might not want to receive as it would be classed as income for tax purposes - whilst remaining exposed to further upside?

I think a great strategy at this moment would be to buy a June 500 put, limiting my downside to $45, or less than 10%, whilst selling a 590 call (covered by a shareholding). The premium payable on the put is $18.35, whilst the premium receivable on the call is $18.10. In other words, I'd have insured my position for virtually nothing.

If Apple shares do fall back dramatically, for whatever reason, then the holder will have the ability to sell out at $500 (subject to revision by dividend amount). Shares would have to rise to more than $608 for the call option to have value for the option holder and shares held would be sold at more than 10% above today's price.

At today's level, I feel the shares have a greater downside risk than upside potential. A move down could be prompted by competition (don't rule out the likes of Amazon and its Fire product to come good), a special dividend payment, a poorly priced acquisition, missed sales targets, or an overall market downturn. Shareholders should be looking to protect the impressive gains that Apple has, thus far, given.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.