Apple Bull Call Strategy - Tactical Trading
October 18 2011 - 8:00PM
Zacks
Before
Apple (AAPL) disappointed investors Tuesday with
revenue and earnings misses, I suggested several option strategies
targeting gains of 43% to 100% in three months.
Today, let's take a closer look at one of those
ideas to see what the potential trade looks like, especially since
it just got a few dollars cheaper to enter. Here's a profit and
loss graph, courtesy of the broker OptionsHouse. This snapshot was
created when the stock was trading around $406.
![](http://www.zacks.com/images/upload_dir/1319050311.jpg)
This strategy involves buying the Jan 375 call for
approximately $47 and selling the Jan 425 call for about $20, for
the net debit of $27 per share. Since an option contract represents
100 shares of the underlying stock, to purchase one spread would
cost $2,700 before commissions.
This graph is based on the potential P&L at
expiration on January 21, 2012. If the spread earns the maximum
profit of $23 per share, or $2,300 per contract, via the stock
closing above the 425 strike at expiration, this will represent a
return of 85% on the capital at risk in only 93 days.
What's the maximum capital at risk? The $2,700
initial debit paid to enter the strategy. When you are buying
options, your loss is limited in this way. And obviously your gain
is limited too since you are short the 425 call option and will
receive no further profit potential above there.
Lots of Profitable Scenarios
Notice that the strategy is profitable at
expiration simply if AAPL is above $402. And you can exit the
spread trade at any time before then and still realize a potential
profit.
If the stock goes up to $410 or higher, say in
November, you might have a small profit on your hands and you could
exit. But your gains in the spread won't be dollar-for-dollar with
the stock. Option spreads like this, even with one call
"in-the-money," are weighed down by the built-in hedge as the
"out-of-the-money" call option you are short rises in value.
If AAPL races above $420 in December, you may have
a very nice profit on your hands. But even if the stock goes above
the 425 strike to $440, your profit won't be the full $23 per
share. It might only make the spread worth $45 with a month until
expiration.
This is the dynamic of option time value at work.
It's not necessary to understand the mechanics of it here. Just
know that these markets are extremely liquid and option prices are
very fair at most every point of the trading day because they are
in a constant state of efficient valuation based on volatility (the
price of risk) and supply and demand.
Billions of dollars are being focused on extracting
pennies of efficiency as professional option market making firms
and their battling algorithms sort out value through relentless
arbitrage and stock replacement.
And Some Losing Propositions
What if AAPL sits around $400 for two months? Well,
the value of the spread will fluctuate around some market value
near its worth, as it is now. Notice that the spread actually gave
you a long, albeit hedged, position in the 375 strike call for less
than the call was actually worth.
But as time passes, the value of the spread will
even more accurately reflect the worth of the in-the-money call. So
it's possible that two months from now, AAPL could be sitting at
$400 and you could sell the spread back to the market for nearly
the same price of $27 that you paid.
What if AAPL goes down to $380 or lower? The spread
will still have value. And that's why you have to decide in advance
what you will do if the stock does take a breather and head south
before we know how many millions of iPhones the company will
sell.
I for one would be looking to add to AAPL long
positions on any fear-driven dips to $360 because I believe the
stock will be higher than $400 come January earnings.
And the great thing about limited-risk call spreads
is that you have very defined, sleep-at-night risk. So you
can relax and wait for your scenario to unfold, all the while free
to do more research and change your mind at any time.
I use these strategies in AAPL -- and other strong
earnings franchises with expensive stocks like Google
(GOOG), CME Group (CME), Netflix (NFLX), and
IBM (IBM) -- because they give me what I want: high returns
for comfortable risk.
Kevin Cook is a Senior Stock Strategist with
Zacks.com
APPLE INC (AAPL): Free Stock Analysis Report
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GOOGLE INC-CL A (GOOG): Free Stock Analysis Report
INTL BUS MACH (IBM): Free Stock Analysis Report
NETFLIX INC (NFLX): Free Stock Analysis Report
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