Last Friday I previewed Apple’s (AAPL) fiscal Q2 earnings (read here) and discussed on CNBC’s Options Action, watch below:
In both I detailed the following hedge for long holders:
If I were long AAPL, concerned that the stock has run too far too fast, worried that no matter how good the qtr and guidance is will not be enough, or a miss and guide down could be met with a 10% plus drop, BUT you don’t want to sell your stock… you might consider a collar strategy against your long stock…selling an out of the money call and using the proceeds to buy and out of the money put in the same expiration, allowing for upside to a point, but most importantly defining risk in the stock to the put strike. An investor would collar their stock if they did not want to sell it but are more concerned with extreme downside into an event or over a stated period of time then they are about capping gains in the case of extreme upside. It also makes sense to place a hedge in the hours prior to the event to make sure the distance of the strikes lines up with your risk targets.
How a collar would work:
VS 100 SHARES OF AAPL LONG AT $204 BUY MAY 192.50 – 212.50 COLLAR FOR EVEN MONEY
-Sell to open 1 May 212.50 call at $2.15-Buy to open 1 May 192.50 put at $2.15
Break-even on May expiration:
Profits of the stock up to 212.50, gains capped above. If the stock is above 212.50 on May expiration the investors could always cover the short call to keep the long position in place.
Losses of the stock down to 192.50, protected below 192.50
The stock was $204, now a few days after earnings the stock is $211. Let’s consider what to do with the hedge.
The Short May 212.50 call that was sold at $2.15 last Friday when the stock was $204 can now be covered for $2.15.
The Long May 192.50 put that was bought for $2.15 last Friday when the stock was $204 can now be sold at 15 cents for a $2 loss.
SO the net of the overlay was a $7 gain in the stock and a $2 loss in the options. I think it is important to remember the reason for putting such a position against long stock in front of a potentially volatile event like earnings… you were willing to give up some potential upside for defined risk to the downside.
So how would one manage this overlay? It really depends on what you want to do with your stock. If you want to stay long then you have to either make a decision when to cover the short call… do you do it now and lock in the loss on the hedge but allow for more upside, or do you wait until closer to May 17th expiration (two weeks) and see if the stock is below the short 212.50 strike and cover for far less than the $2,15 in premium today, or let expire worthless. At this point It likely makes sense to give it a few more days as the stock seems to have lost a little steam from its initial post-earnings gap of 5% that was in line with the implied move. But at this point, it is very clearly a sort of market call.