Dan presented a fairly comprehensive preview of the issues AAPL faces ahead of earnings tonight. I wanted to pivot off of that post and look at some options structures into the print that offer protection for existing longs, add leverage on a rally for longs that are underwater and some longer term structures for those that don’t have a position but think that AAPL stock is close to establishing a reversal point and is due to go higher over time.
Protection for Longs
Let’s start with existing longs that have would like to be long term owners of the stock. A great way to stick around in a stock long term is to put on protection into worrisome events like earnings and product releases. Basically the way it works is by capping your stock on the upside where your only “risk” is a large gap higher can be slightly less profitable to you than it would have been as a naked long. What you get for that “sacrifice” is the ability to stay long without worry about getting killed by a gap to the downside. So how would this work in AAPL?
The first thing we want to look at is where is the spot to the upside in the stock we’d be willing to give up our long in order to buy some protection. The other factor is what month and strikes would we want to pick in order to get enough premium on the sale to the upside that we can finance a fairly tight hedge to the downside. One trick we use for strike selection is to look to the technicals in the stock to determine likely points where a stock would meet resistance or support. In the case of AAPL we have a couple key areas of potential support and resistance:
Going into earnings the stock just got rejected at its 50 day moving average of around 430 but if it was able to break above that on a better than expected earnings report it’s got to get through a couple of spots where sellers likely lurk, and would have serious trouble going high than its 200 day moving average which currently sits just above 485 (and dropping.) We can use that area a a spot to sell an upside call. If we’re long this stock, there are worse things in the world than seeing it called away from us almost 60 dollars higher.
To the downside we have a few levels that look important, 420, 400 and maybe most important than all the 385 area which is the recent lows that the stock bounced off of twice. If we use 385 as a target to the downside we have two choices, do we buy tight protection that protects us down to that level and uses 385 as support that the stock could bounce off of? Or do we buy disaster protection below 385? For the purposes of this example I’m going to do tight protection and assume that the stock will hold 385 on the downside considering how much it’s down from its highs of 700. So here’s the trade:
Theoretical Hedge vs AAPL (~$425) long – Sell the Jan’14 480 call to Buy the Jan’14 410/385 put spread for ~even $
- Sell 1 Jan’14 480 call at 9.70
- Buy 1 Jan’14 410 put for 25.20
- Sell 1 Jan’14 put at 15.50
I like this structure as it gives fairly tight protection on the downside (410) to where the stock is trading (425) and basically takes the bite out of a move in the stock back to its recent lows of 385. Below 385 the protection is lost but you will have lessened the blow by 25 dollars and considering the options market is only pricing in about a 20 dollar earnings gap in AAPL, that’s a good risk reward. And again, the hope is that the stock breaks above, and to only be called away in your stock at 480 to get protection so close on the downside seems like a no brainier for longs that would rather not be biting their nails going into the print.
Leverage for longs
So what about longs that bought higher in the stock, aren’t so worried about more downside but would really like to get back their money more quickly on a rally and be done with the stock?
With vol this low this becomes somewhat tricky. We like to use 1×2 call spreads to the upside for this purpose which act as both a supercharge to the upside for your long but also are net short volatility at elevated levels and do really well after earnings if the stock doesn’t do much of anything. With AAPL vol historically low (event wise) into the print this one isn’t as good as it normally is but still worth considering.
Theoretical Trade to Add Leverage on Upside for Existing AAPL (~$425) longs – Buy the Nov 460/485 1×2 Call spread for a 60c credit
- Buy 1 Nov 460 call for 10.20
- Sell 2 Nov 485 calls at 5.40 (10.80 total)
This structure also isolates that 200 day moving average but gives the long holder a 25 dollar area where his/her long is “supercharged” essentially being called away in the stock at 485 as if they sold it at 510.60 on November expiration if AAPL is at or above 485. Even if the stock is below 485 on Nov expiration but above 460 the structure will have gained additional yield on the existing long.
Defined Risk Long Exposure
Let’s say you’re not long AAPL, would like to be as you think the stock is establishing a bottoming process, but don’t want to take on a ton of risk in case you’re wrong. There are a couple of ways to play this. Let’s look first at a structure that is for those that think AAPL is likely bottoming but don’t expect a ton of upside and maybe think the stock is in the middle of a new range but has potential to go up and test that 200 day moving average in the next few months.
Theoretical Range Bound Long in AAPL (~$425) – Buy the Jan’14 410/460/510 Call Fly for 11.30
- Buy 1 Jan’14 410 call for 34.50
- Sell 2 Jan’14 460 calls at 14.20 (28.40 total)
- Buy 1 Jan ’14 510 call for 5.20
What this structure does is essentially get you long AAPL at 421.30 but instead of outright buying the stock or paying alot of premium for out-of-the-money calls to the upside it get’s you long where your risk is only 11.30 or a little over 2.5% in the stock, and your potential on a move to the upside could mean about a 4 to 1 maximum payout and lots of scenarios where you make money if the stock can get back above its 50 day moving average. Your main risks on this trade is if AAPL stock really is Cooked and will continue to make lower lows the rest of the year. You have slight risk of a gap up in the stock but it would have to be pretty massive for you not to make money on a rally in the stock after earnings. You would basically need stock to gap up to above 500 pretty quickly in the next few days (not likely.)
If that one is a little tight for you and you really think this is it, and want to be there for AAPL stock’s big turnaround we can look at another defined risk structure.
Theoretical Long for AAPL (~425) Stock Turnaround – Buy the Apr’14 425/500/575 call fly for 14.50
- Buy 1 Apr’14 425 call for 33.50
- Sell 2 Apr’14 500 calls at 11.20 (22.40)
- Buy 1 Apr’14 575 call for 3.40
On this structure we don’t get the benefit of “owning” the stock lower or right where it is, but we get a much better situation to the upside if AAPL does truly start to rally in the 6 to 8 months. What’s nice about this structure is your big payoff is if the stock is 500 on April expiration, but you only really need one attempt at those levels in the meantime to be able to take it off for a nice winner. You have basically no risk to the upside for this earnings event, and your only risk is if the stock tanks and or is left for dead.
So a number of ways to play this event both for longs and those that want to be long. We would obviously love if AAPL sold back to its lows following these earnings to make entries on the long side that much better, but with the stock where it is, these structures offer both protection down to those lows and some defined risk plays to the upside that won’t hurt as bad as other ways to get long if proven wrong with an immediate sell-off on earnings.