Anatomy of a Trade – $AAPL Oct Risk Reversal

by CC May 25, 2016 1:28 pm • Commentary• Trade Ideas

On May 12th, when Apple (AAPL) was threatening the $90 level we detailed a long delta trade for those looking to wade into the stock. We liked the idea of risk reversals that gave some time and caught the build up to the iPhone 7 release in late September, with $80 as a level where one should be more than willing to be put stock. Here was the trade idea from May 12th:

with the stock at $90.65, you could sell the Oct 80 put at $2.50 and buy the Oct 100 call for $2.75, resulting in a net debit of 25 cents.  If the stock is between $80 and $100 on October expiration, then you would lose the 25 cents in premium spent for the trade. If the stock is below $80 you would be put 100 shares per 1 contract sold and suffer losses. If the stock is above $100.25 you have gains of the stock.  What’s nice about this trade structure is that it offers a wide range where there is a minimal loss on October expiration, while offering some wiggle room to the downside in the event the stock sees lower lows.  But what is attractive about the trade is the potential leverage to the upside in the event the stock catches some momentum into the much anticipated product launch in the fall.

With the stock now approaching $100 it’s a good time to check back in and see what adjustments will reduce overall risk and set-up for a follow through over the Summer. With the stock $99.50 this risk reversal is now worth about $4.80. That’s about half the move in the stock and that makes sense given that it was about 50 deltas when the stock was $90.65.

As it stands now that risk reversal is about 50 deltas. As time goes by those deltas will change depending on where the stock is. Above 100 and below 80 near October expiration will mean it’s close to 100 deltas (like being long AAPL above 100 and below 80 but not in between). So it’s like an order to own AAPL stock only if it breaks out back above 100 or if it dips below 80, which acts like a good til cancel order below.

At $99.50 this trade has about 60 deltas. The short puts are only about 10 deltas now while the 100 calls are about 50 deltas, so the meat of the trade is in the at-the- money calls now, with the puts at 10 deltas probably a good candidate to cover or roll now. There’s two good ways to adjust this trade. The first is to roll the entire trade higher, closing the 80 and 100 lines and re-initiating the position as short Oct 90 puts and long Oct 110 calls. This reestablishes the 50 delta trade and ‘books’ the profits from the original trade. The only issue for this roll is it doesn’t really ‘book’ the profits. That better way to look at is it rolls the level that one is willing to be put the stock higher, but less the profits already made. So with the 4.80 or so made so far plus the 50c or so credit that can be taken in by doing the Oct 90/110 risk reversal, it’s like having a new good til cancel buy order below at $85.

AAPL 2yr chart from Bloomberg
AAPL 2yr chart from Bloomberg

The second way to roll, and probably the more prudent after this nearly 10% rally in the stock is to reduce deltas and keep some of the upside potential. The way to do that is to close the put side of the original risk reversal entirely, and turn the existing long Oct 100 call into a vertical call spread. So one could buy to close the Oct 80 puts for 90 cents (for 1.60 profit) and then sell to open the Oct 110 calls at 2.10 (essentially locking in 2.10 of the 2.80 gains in the Oct 100 calls).

The resulting position in that roll scenario is an Oct 100/110 call spread for a credit of 85 cents. (currently worth about 3.50). The call spread has a long delta of about 25, and has the potential to be worth up to $10 if the stock is at or above $110 on October expiration. This roll actually does lock in 85 cents in profits, with the potential to make another $10. Of course, if the stock is below 100 on October expiration all the mark to market profits (less the .85) at the moment are lost, so it is letting those ride for higher highs. But it also frees up margin with a short put no longer being part of the position.

For those that were simply playing for a move to 100 and are happy with the profits, the entire trade can of course be closed for over a 4 dollar profit.

Here was Dan’s description of the Trade strategy on CNBC’s Options Action on May 13th: