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Trading Volatility In Apple Ahead Of Earnings.

|Includes: Appell Petroleum Corp. (APPL)
Summary

Why Apple makes a good short premium play.

Quantitative Analysis.

How to set the trade up.

How to manage the trade.

Follow me on twitter @Spencer_Enos.

Apple (OTC:APPL) is scheduled to release earnings for the fiscal quarter ending September 2018 after the bell on 11/01/2018. Apple has recently sold off in the recent weeks alongside with overall equity markets. Apple closed at $216.30 a share on 10/26/18, which is nearly 7.5% off it’s recent highs of $233.47. With no real justification for the sell off, I like the idea of getting long Apple ahead of earnings. But instead of shelling out over $20,000 for just one hundred shares of stock, there's a more capital efficient strategy, with a higher mathematical chance of profit if you're bullish on Apple. Let me explain…

Volatility

As a derivatives trader I seek out high volatility, liquidity, and oversold stocks to add long delta to my portfolio. Apple fits that category with an 89 implied volatility rank (as of 10/26/18), and being one of the most liquid stocks. Apple is expected to have an $11.64 move in either direction following its release of their earnings. At the current price of $216.30 as of market close on 10/26/18 that would represent a target price range of $204.66 - $227.94 or a 5.5% move. This is according to the implied volatility (37.8%) pricing of Apples' front month, weekly expiration date on the options chain (Nov 2, 18). 

tastyworks

(tastyworks)

The further dated monthly expiration (Nov 16, 18) has a lower volatility of (34.3%) which is nearly a 8.5% difference. This in theory should represent a volatility contraction after Apple releases their earnings, which would benefit option sellers. 

Strategy

Price action following earning events are random, meaning the directional move of a stock following earnings is a 50/50 trade. That's why a more neutral strategy, while still having a bullish assumption by selling a put in Apple ahead of earnings is a better option(pun intended).

Selling a put is a bullish strategy on Apple, but there's much more room to be wrong if the stock goes down following earnings. This is because option sellers improve cost basis which in turn statistically improves the probability of profit on a trade, and takes out the 50/50 directional aspect. 

The 200 put strike in the Nov 2, 18 expiration would provide a downside protection of $16.30 or a 7% move in Apple, whereas the expected range for Apple following earnings is only 5.5%. The 200 put strike has a delta of 22, and a probability being out of the money (OTM) of 76%. It's also just inside the one standard deviation mark which represents nearly a 68% probability of profit. Even though this is a bullish strategy, Apple can still trade lower, or not move at all, and it would be a profitable strategy.tastyworks

(tastyworks)

If Apple trades less than the expected move the day after earnings, volatility in the stock would decelerate from its current rank of 89, which option sellers would be able to collect the theta as premium would dissolve in the options. So not only is selling the 200 put a way to profit from direction, it's also a way to profit off of a volatility deceleration.

Trade Set Up

As I mentioned earlier, the trade is to sell the 200 put in Apples' Nov 16,18 expiration cycle. There's plenty of liquidity in the 200 puts, with an open interest of over 35,000. The buying power reduction is about $2,500 for this trade. Depending on when the trade is executed, expect to get somewhere around $3.50 as a total credit which would improve your breakeven to $196.50. The total max profit on this trade would be the total credit received, multiplied by one hundred making $350 the maximum profit if Apple stays above the 200 put strike on the expiration date. The number of contracts sold would increase the maximum profit, for this example I'm using one contract. The maximum loss of this trade is theoretically about $20,000 if Apples' stock goes to zero by the expiration date. 

Trade Management

By only needing $2,500 to execute this trade, and assuming a $3.50 credit is received, that would make the potential return on capital 14%. I'll look to close this trade if there's any reduction in volatility following Apples' earnings, or if Apples' stock has a lower outcome than the expected move which should immediately make the trade profitable. I won't expect to receive the full credit because I won't be holding this until expiration. I'll be looking to buy back my put option around 30-50% of maximum profit the day after earnings. If Apples' stock drops below my breakeven, I'll roll it out to the next monthly expiration (Dec 21, 18) at the same strike price. 

Summary 

I don't have much of an opinion on the fundamentals of the stock, or reasons why it might go higher or lower after earnings, this is a pure quantitative play. Selling the 200 puts gives me 7% downside protection when the expected move according to Apples' implied volatility in

 the Nov 2, 18 expiration is only 5.5%. So I don't need to be right directionally, which takes picking a direction out of the equation. If the actual move is less than the expected 5.5% range, premium should revert back to the mean, making the 200 put worth less than the credit received. I'll look to make about 7% return on capital in one day.

I'm planning on placing the trade the day before earnings because that's usually when volatility is at its highest point, making the options the most expensive, which will in return make the credit received higher. 

By the time you may read this article Apples' stock will more than likely be at a different price than mentioned above. This would affect the numbers, and statistics used for this article. The same philosophy will still apply, by selling the 20 delta put strike on the Nov 16, 18 expiration. The 20 delta strike may not be the 200 put strike depending on where Apples' current stock price is at the time of order execution.

Good Luck!

Disclosure: I am/we are long AAPL.

Additional disclosure: I am not a register financial advisor, nor am I recognized by the SEC as a legal investment advisor. This is not advice, or recommendations of any investment. This is solely my opinion, and the content of this article are for entertainment purposes only. Options include risks and may not be suitable for all investors. Please visit www.nasdaq.com/... for more information about the risks associated with options.