Don't Trade Apple Earnings Without Reading This First

| About: Apple Inc. (AAPL)
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Apple (NASDAQ:AAPL), the biggest publicly listed company on the planet, is about to announce earnings on April 24th, after markets close. It is estimated that nearly 200+ Hedge funds have AAPL shares in their portfolio. And it is one of the most commonly talked about stocks on almost every mainstream financial meduim, website, forum, and blog.

Here are some of the interesting things you may want to know before you go for an option trading strategy.

Since the last quarter earnings announcement, AAPL stock is up roughly 40% (@$586 current market price). During this time, normally one would expect implied volatility (IV) to drop (and rise before the next earning announcement). However, AAPL's implied volatility (IV) almost doubled during this period.

Click to enlarge.

What does that mean? Let's say you purchased 5 AAPL Oct 550 calls (almost 9 months life) on Jan 26th (after earning announcement and IV collapse). The cost was $880 per contract, thus costing you $4,400 for 5 contracts. Each call today - had IV remained where it was at 25% (Options IV is different from stock's IV) - would be worth $6200 with AAPL is at $586. However, due to a rise in IV to 37.5% from 25% for this specific option, the actual price is $8,100. Thus you have been rewarded an additional $1,900 per contract ($81-62= $19) just because of this unusual rise in IV. And your $4,400 investment would be worth $40,500 today, including $9,500 due to just the IV rise alone.

From another observation, Just as Implied Volatility is rising, so is 10 day historical volatility (HV10). Usually, historical volatility is stable going into earnings announcements. The rise in HV10 is driven by a recent drop in AAPL's price.

For the first time since mid-December 2011, AAPL dropped below its 20 day moving average on 13th April, and since then it is finding it hard to close above it. The 50 day moving average is not too far ($569) either; and long term support of the 200-day moving average is at $439. This bearish drop doesn't mean AAPL is headed for $439, but these are the key numbers that you may want to keep in mind when dealing with any scenario. The all time high is $644.

Look at the volatility skew. The skew between April weekly options (expires next week) and May series is a huge 15 to 20%. And skew between May and June monthly options is another 4%. These are not small numbers for a stock like AAPL. If AAPL sneezes, it is likely the rest of the market will catch cold.

Financial portals and blogs will be filled with numerous option trading strategies on how you, the retail investor, can make money from this wonderful opportunity. One of the most common strategies will be to sell straddles just before the market close. The straddle allows you to leverage the volatility crush.

Here is a chart that may provide some perspective (courtesy of LiveVol) on how straddles have performed during past quarters - mixed, to say the least.

While most people will count return based on credit received by selling those options, the correct way to count return is based on capital employed. If you were to sell say AAPL weekly ATM 585 straddle today, it will cost you almost $17,000 in the margin and you will make $0 to $4,400 if AAPL is in between $540 and $630 by next Friday. If AAPL moves beyond these points, the losses can be substantial.

So let's combine what we know-

  1. AAPL IV almost doubled during the past quarter, and is elevated now for front, back and next month.
  2. The stock has risen almost +50% in 3 months.
  3. It has recently dropped below 20 dma for the first time in 2012.
  4. There are almost 200+ hedge funds invested in this stock. What if the 800-pound gorillas want to exit for whatever reason?
  5. Goldman Sachs (NYSE:GS) just upgraded the stock.

There is uncertainty, and that's what is reflected by the implied volatility. So, here are key things you may want to note when you craft your strategy:

  1. A strategy that is long premium will face direct headwinds in terms of IV collapse.
  2. Any strategy that involves naked selling premium on a stock that has rallied +50% opens one to sharp tail risk.
  3. A market neutral, also known as delta neutral, strategy may not work if stock moves sharply in either direction.

I shall write more before the earnings, sharing some more interesting ways to play AAPL earnings.

Disclosure: I am short AAPL.

Disclaimer: Option trading can be risky, and you may lose your capital quickly if not done properly. Please do your due diligence before investing any money based on above. This article is for informational purposes only.