Anatomy of a Trade: $AAPL Jan 1×2 Call Spread

by Enis November 20, 2012 12:29 pm • Commentary

With AAPL up about 10% from its intraday lows on Friday, the  Jan13 540 / 580 1×2 call spread that we initiated on Thursday, Nov 15th is currently a losing position. We wanted to walk through our current thoughts on the position, and our initial thoughts as we executed the trade last week.  

First, a few comments on why we chose this trade structure last week. On Thursday, we were confident that AAPL was close to a short-term bottom, but not confident enough to pull the trigger on a long-delta trade. As a result, we thought a 1×2 call spread would be a better initial structure, essentially a short volatility trade that is flat delta. We knew that our risk would be a rapid move higher in AAPL, but we felt that the many weeks of selling and overhead supply would serve to cap any short-term rally in the stock. In addition, the severe oversold nature of the stock chart suggested to us that any initial bounce would be met with more selling, before the stock built a more sustainable base for a longer term rally.

As we saw AAPL start to capitulate on Friday, we became more comfortable betting that AAPL was close to a short-term bottom, and bought the Dec 1×1 call spread. We also wanted some “delta” protection against our Jan13 1×2 call spread that we traded on Thursday, since we knew that was more a short volatility trade than a directional bet. (Although short volatility is bullish, generally)

Fast forward to today. AAPL stock has rallied more than 50 dollars from its intraday low on Friday morning, a spectacularly quick rally. The Dec 1×1 call spread worked out well, so well that we took the gains only one trading day after we initiated the trade. However, the Jan13 1×2 call spread has lost money on the way up, and more than our expectations. The biggest difference in what has occurred relative to our expectations when we initiated the trade on Thursday has been the move in implied volatility in AAPL. We assumed that if AAPL rallied 5-10%, implied volatility would come in handily. In contrast, implied volatility is actually higher than when we initiated the trade, a rare scenario of stock higher / volatility higher (normally, it’s stock higher / volatility lower). This is due to the violent nature of the past few days’ moves.

What do we do with our 1×2 call spread since it has not performed as expected? The fact that AAPL moved 7% yesterday justifies the higher volatility to a certain extent. In other words, simply the fact that AAPL is realizing more volatility will likely keep implied volatility elevated. In that sense, I’m less comfortable with a short volatility bet on AAPL here. Having said that, I think the technical nature of AAPL’s chart is quite similar to what I expected to unfold when I initiated the 1×2 call spread on Thursday. AAPL has likely put in a short-term bottom, but significant supply looms overhead. Given that, I do think the Jan13 540 / 580 1×2 call spread is more likely than not to be a decent winner by expiry (with the stock between 540 and 620 by Jan13 expiry).

But the real risk lies in the interim mark-to-market moves of the position. If AAPL looks like it could rally above 610 in the next few weeks, I might look to readjust the position to reduce my upside risk. Moreover, if AAPL sells off back near 530 in the next few weeks, I might look to buy back 1 of my short Jan13 580 calls, turning the 1×2 call spread into a 1×1 call spread and thus turning the position into a long delta / long volatility position or simply close the spread on the way down for a profit.

We hope this discussion helps you understand our own thoughts when we consider trade structures before and after we’ve traded them, and how our game plan evolves as the market evolves.

As it stands now the greeks other than Delta are quite favorable to the trade. The structure collects decay every day, no small thing considering the upcoming holiday. It also is short vol at levels that would likely see compressing vol once the stock stops moving so much intraday. The main issue becomes the deltas though. The structure is more than 20 deltas short, and that becomes the issue here with the structure.

So to summarize, the different scenarios are:

  • stock goes up nearterm – bad because of short deltas
  • stock goes down nearterm – good because of short deltas
  • stock goes sideways nearterm – good because of decay and vol coming in
  • stock goes down slowly near-term – great because of decay, deltas, and vol coming in