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

by Enis November 26, 2012 2:22 pm • Commentary

Update #2, Nov 26th, 2012:

We’ve gotten some questions today on the long AAPL Jan13 540 / 580 1×2 call spread that we bought for $3.20 back on Nov 15th.  The stock has rallied much more sharply than we expected, leaving us managing a losing position as implied volatility has stayed high and our trade has become short delta.

We laid out our thoughts on this trade last week, included below.  We wanted to update those thoughts with the stock around $587 today.  

First, I initiated this trade on Nov 15th with the expectation that the stock would rally.  I obviously did not expect such a rapid move, but I knew that my risk was that the stock moved higher very quickly.  As a result, I initiated the trade with plenty of room for error, meaning I did not risk too much capital in case the stock did get above my 617 breakeven area by Jan13.

With that in mind, I plan to do nothing with the position right now, even though it is currently a mark-to-market loser.  The stock is close to the middle of my profitable range between 543 and 617, so I am comfortable holding it here.  BUT, there could be more mark-to-market pain for this trade going forward if AAPL continues to rally.  In that vein, here are some of our thoughts on why we chose to do nothing, but what we considered as potential adjustments:

  1. Turn into a Jan13 540 / 580 / 620 call butterfly:  You could do this by buying the Jan13 620 call for around $15, which would make you long the 540 / 580 / 620 butterfly for a cost of $18.20.  Clearly, the odds would be stacked against you in making money on this trade, which is why I don’t like it.
  2. Roll the Jan13 540 / 580 1×2 call spread into the Jan13 560 / 600 1×2 call spread:  This would involve selling my long Jan13 540 call, and buying the Jan13 560 call in its place, and buying back the short 2 Jan13 580 calls, and selling 2 Jan13 600 calls in its place.  This would cost me an incremental $5, taking my cost base on my new trade to $8.20.  So I’d be long the Jan13 560 / 600 1×2 call spread for $8.20.  I think AAPL is likely to remain below 600, so I don’t want to pay the extra premium for this trade, but it’s a good alternative for those who think 600 is the real midpoint of the range going forward, as opposed to 580. This is probably the best hedge we came up with if mark to market risk is the biggest concern. The trade could get worse on a mark to market basis if the rally continues, so even though the breakeven on the trade is much higher, this roll allows one to take deltas off the table (and raising the profit zone) for that scenario without sacrificing a huge amount of profit potential.
  3. Take the whole thing off. This is what we’d do if we were confident in AAPL’s rally continuing to above our breakeven point.
  4. Do nothing.  I prefer this option because I am comfortable with the mark-to-market losses in the context of a longer term range-bound thesis for AAPL stock that I still have.  To choose this option though, your sizing of the trade has to be small enough to ride the mark-to-market swings.

Here’s a P&L chart with two time periods, one today (red), and one in January (purple.) As you can see, at this point the mark to market risk is entirely the short deltas of the trade. Stock goes up, trade loses money. Stock goes down, stock makes money. As we get farther towards Jan, that chart will become more and more like the purple line, where 580 is the best case scenario and any movement in the stock above or below that is worse. The P&L breakdowns below the chart are based on 1×2 contracts.

[caption id="attachment_19777" align="aligncenter" width="621" caption="AAPL 1x2 Risk chart from LiveVol X"][/caption]



Original Post, Nov. 20th, 2012:

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