Webinar: Trading AAPL’s Fiscal Q2 Earnings With Options
Here is the link for further review: https://attendee.gotowebinar.com/recording/4615196009414955008
OUR PROCESS: Anatomy of an Earnings Trade With Options
1. Determine the back of the napkin implied move calculations using weekly options, then walk through our Implied Move Calculator which uses the next two months to calculate.
2. Determine historical average moves following earnings.
3. Develop directional thesis using the following inputs:
a. Implied move vs historical
b. Fundamentals; valuation, product cycles, competitive pressures, corporate action etc
c. Sentiment; analyst ratings, price targets, short interest, change in estimates
d. Price action and technicals, have a view on where the stock has been and where the charts suggest it could be going.
e. Volatility, get a sense for what base vol should be in the name, and where it is likely to settle after the event; this is tied to the implied move, but when evaluating different structures and expirations to express the view.
4. Once Directional thesis and vol view established, arrive at the the most cost effective way to express the view. In some instances we will arrive at the conclusion that we have little edge after evaluating the event from both a qualitative and quantitative approaches and decide not to play.
AAPL Fiscal Q2 Earnings Preview
Event: AAPL reports Q2 earning tomorrow after the close. The Options Market is implying about a 7.5%*which is slightly rich to the 4 qtr average move of about 7%.
* the Apil 26th 390 straddle is offered at about $29, if you were to buy that you need a $29 move in either direction to make money on Friday’s expiration, or about 7.5%).
Sentiment: Despite more than a half dozen ratings downgrades in the last few months, Wall Street analysts remain overwhelmingly positive on the stock with 51 Buys, 11 Holds and only 3 Sells with an average 12 month price target of about $582 (or almost 50% higher than current levels). Short interest nears 52 week highs, but only at about 2% of the float.
Fundamentals: There is obviously a raging debate among bulls and bears on this one as to the potential for future growth and innovation. My sense is that AAPL will have its share of fits and starts as a stock over the coming qtrs/years as the investor base shifts from growth to value. Business Insider’s Henry Blodget has had 2 great posts of late succinctly laying out the bull/bear debate (here), so here it is:
BULL:
- The stock is cheap. ($366 bil market cap, close to $150 bil in cash, no debt, generating about $40 bil in cash a year, with cash balance equaling its trailing 12 month sales)
- We are nearing the end of the new-product blackout that began last fall. (In relatively short order, excitement should begin to build about the iPhone 5S, the new iPad Mini, and other product refreshes)
- While Apple’s management team without Steve Jobs in charge is unproven, it’s not stupid. Almost all of the folks who produced and sold Apple’s great products over the past five years are still on the team.
- Apple appears to be working on a cheaper iPhone, which suggests it is finally willing to trade profit margin for growth. This is critical for the company’s long-term survival….
- A disastrous first quarter and second-quarter outlook should radically reduce Wall Street’s expectations for Apple — thus setting the bar lower. This will make it easier for Apple to positively surprise investors in the future.
- It is still possible that Apple is working on a revolutionary new product like a TV or smartwatch that will suddenly get people jazzed about the company again.
- Most importantly, Apple is still well-positioned strategically, and it still makes excellent products.
BEAR:
- The company’s growth has vanished: earnings are expected to shrink this year.
- The company’s critical product, the iPhone, has lost its edge, and the product cycle that drove Apple’s mind-boggling profitability over the last several years (premium smartphone growth) is nearing its end.
- Apple’s profit margin is dropping, as its main products get commoditized.
- The CEO of the company is not a product visionary, and has not articulated a vision of where he wants to take Apple going forward.
- Apple’s internal management may be in turmoil or at least in flux, and employees are reportedly more willing to leave than they have been before
- No one knows if Apple has any truly great new products in the pipeline.
- Apple has cash coming out of its ears, but no clue what do with it.
- Apple’s first quarter results (coming next week) are likely to be disappointing, and the company’s outlook will likely force Wall Street to slash its future estimates.
- Lastly, Apple really has finally entered the “post-Steve Jobs” era, and it remains to be seen how successful the company’s next generation of leaders and products will be
Tablet and Mobile Share (Courtesy of BGC)
Technicals:
The stock has gotten very close to longer-term technical support around $360-$370, which is also close to the 200 week moving average:
Given how many months the stock traded in that area, that area is by far the strongest support area AAPL has encountered on its many months of selling. At the least, even if AAPL breaks that area of support (something I think is low probability), we don’t foresee AAPL declining much more from there in the short-term. There is too much price memory in that area overall. In terms of resistance, the 475-500 area should be tough to breach in the coming months based on all of the potential overhead supply.
On a longer-term basis, the 5 year weekly chart shows that AAPL has broken its multiyear uptrend in 2013:
Just one more confirmation that AAPL is unlikely to reclaim its previous heights anytime soon.
Volatility: Implied Vol in AAPL is nearing 2 year highs, and at the highest it has been ahead of earnings at any point. The only time implied vol was higher was due to macro concerns in the fall of 2011, when the VIX got all the way to 48. This has occurred as realized vol has also moved higher, but 30 day realized vol in AAPL is only around 30, around the midpoint of its 2 year historical vol. So option traders are placing a lot of emphasis on next week’s earnings report, and expecting a bigger move than usual.
OUR VIEW: Very simply put, we think the stock is setting up for a capitulation bottom. I even said it could be the “BUY OF THE CENTURY on the NEXT PUKE” the other day on Fast Money. I am fairly certain most traders know what I mean, if the stock craters on news that was expected, we could see a set up for a V Reversal back towards LONG TERM SUPPORT, that would also match a 50% peak to trough decline from the September Highs.
Readers of Risk Reversal are very well aware that we are not in the business of merely buying and selling stocks at certain levels, we look for ways to marry all of the inputs detailed above with our directional view and arrive at the best way to express that view with DEFINED RISK. If AAPL’s Q2 earnings and Q3 guidance cause a massive gap in the stock on Wednesday morning, we will likely employ one of the following strategies:
TRADES WE ARE CONSIDERING:
A) NO EXISTING STOCK POSITION
1) Theoretical Trade: AAPL ($395) Buy Jan2014 400 / 500 /600 Call Butterfly for ~18.00
- Buy 1 AAPL Jan14 400 call for 40.00
- Sell 2 AAPL Jan14 500 calls at 12.50 each or 25.00 total
- Buy 1 AAPL Jan14 600 call for 3.00
Break-Even on Jan14 Expiration:
- Profits of up to 82 btwn 418 and 582, maximum gain of 82 at 500
- Losses of up to 18 btwn 400 and 418 and btwn 582 and 600, with max loss of 18 below 400 and above 600.
Trade Rationale: In any trade that I am committing long premium to, I need to establish some potential catalysts, and give myself enough time and a wide enough range so that I have time to have the thesis play out. I will likely chose Jan14 so that I can capture new products in the fall and 2 additional earnings event. I will likely choose the fly to reduce my premium outlay by selling 2 of the middle strike in an effort to widen the range of the spread as opposed to just a one up call spread. This trade structure is almost a set it and forget it sort of trade as I will risk what i am willing to lose. The main point though is that this structure gives me time and room to participate on a turn in sentiment, without having to worry to much about the near term volatility.
Payout Diagram:
2) Trade Prior to Earnings: AAPL ($395) Buy July 375 / 425 / 475 Call Fly for $13.50
- Buy 1 AAPL July 375 call for 35.50
- Sell 2 AAPL July 425 calls at 13.00 each or 26.00 total
- Buy 1 AAPL July 475 call for 4.00
Break-Even on July Expiration:
- Profits of up to 36.50 btwn 388.50 and 461.50, maximum gain of 36.50 at 425
- Losses of up to 13.50 btwn 375 and 388.50 and btwn 461.50 and 475, with max loss of 13.50 at or below 375 and at or above 475.
Trade Rationale: In This is a structure I want to put on before the earnings announcement since it is primarily a short volatility trade rather than a purely directional play. It is only a 0.09 delta structure, meaning the value of the structure will change by approximately 0.09 in value for each $1 move in AAPL’s stock price, all else equal. However, it will move approximately 0.30 for each 1 point change in the July implied volatility of AAPL. So in the short run, the volatility impact will be more significant than the directional impact, for small changes in the stock price. If I expected the stock to move more than the 7.5% implied move, then this is probably not the right structure. But since I view the stock’s downside as limited by its fundamental value and long-term support, and its upside limited by all the previous buyers who are waiting to unload their stock on a rally, I like playing for a rangebound situation over the next 3 months.
This trade’s real appreciation, though, would occur as we approach expiration, closer to July. In the meantime, it’s a low risk way to play for AAPL to stop going down, and for volatility in the stock to subside.
Payout Diagram:
B) AGAINST EXISTING LONG STOCK POSITION
1. Take Advantage of Elevated Implied Vol Ahead of Earnings: Yield Enhancement
Given the high level of AAPL implied volatility, we prefer trade structures that are net short volatility. The following trades are both of that nature.
TRADE: Against A Long Stock Position in AAPL (~$395) Buy June 425/450 1×2 Call Spread, Collect $0.25
- Buy 1 AAPL June 425 Call for 10.95
- Sell 2 AAPL June 450 calls at 5.60 each or 11.20 total
Break-Even Expiration:
- Collect 0.25 initial premium on the options structure if AAPL at or below 425 on expiry
- Profits on the 1×2 Call Spread btwn 425 and 450 of up to $25, max gain of $25 with stock at $450 (added around a 6% yield with stock up ~15%)
- If stock is above $450 on June expiration, your long stock will be called away at $450, so you have made $55 in the stock from the current level, but you have also made $25 from the 1×2 call spread.
- Think of the trade as a levered over-write, a sort of super yield trade.
- Losses from the long stock below 395, with a small 0.25 from the options structure.
Payout Diagram:
Trade Rationale: You would only layer this structure on a long if you had confidence that the stock would go higher after earnings with the possibility for the stock to meet resistance around its prior high.
2. Put Spread Collar Against Long Stock – Risk Management
TRADE: Against A Long Stock Position in AAPL (~$395) Sell May 420 Call to Buy May 390/370 Put Spread for Even Money
- Sell 1 May 420 Call at 8.05
- Buy 1 May 390 Put for 17.05
- Sell 1 May 370 Put at 9.00
Break-Even on Expiration:
- Stock Profits of up to $25 btwn 395 and 420, max gain of $25 or around 6% at 425 or higher as stock is called away.
- Losses of up to $5 btwn $395 and $390, losses below $370 of stock, but you have made $20 on the put spread, so really you risk $5 of downside (1.25%) btwn $395 and $370 (down ~6%)
Payout Diagram:
Trade Rationale: You would do this against a long stock position if you were worried about the event risk related to earnings, but did not want to just sell the stock ahead of the event in case the stock went higher. This trade structure leaves you naked long below $370, but offers some protection on the event and makes it less likely that you would panic on a big move lower. This is not a great structure if you feel this earnings could be the big one that finally turns the stock back to the upside because your gains are capped so close to the upside.
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