Ahead of AAPL’s earnings tonight, I just sold half of my Jan25th 525/550/575 call fly that I traded on Friday for a double. My thought is that I can take my premium off the table, and stay in the game with half the position for tonight’s earnings, while only risking the house’s money.
ACTION: Sold to Close Half of AAPL ($514.30) Jan25th 525/550/575 call fly at $6.00 for a $3.00 gain, remain long the other half with cost base of $3.00
Original Trade Jan 18th, 2013:
Earlier this week, Enis and I did a fairly deep dive Webinar (below) on how we were thinking about the setup into AAPL’s Q1 earnings slated for Wednesday, Jan 23rd after the market close. We ran through many of the inputs we use both from a qualitative and quantitative perspective to arrive at our trade structures, and frankly not much has changed since Monday.
The implied move for earnings (Jan 23rd post close) has ticked up a tad though, now about 7% (with the stock at $500 the Jan25th 500 straddle is offered at about $38, or a little over 7%). So here’s the trade:
My thought here is that the implied move makes sense from the standpoint of the stock’s massive relative weakness, recent sentiment shift and all of the uncertainty surrounding the rate of decelerating growth. As a trader, my sense is that the sentiment shift of late is a bit overdone, and while the stock could still see $450 on a meaningful Q1 miss and guide below current consensus, I imagine buyers would step in at levels that represent a round trip of the historic 12 month run.
While investors want to look out past the recent weakness, and anticipate catalysts such as share buybacks, increased dividend, distribution deal with China Mobile and the entrance into a new category such as TVs, the trader in me wants to just isolate next week’s event.
While in some ways I would love to see the stock just completely fall out of bed, I think the greater likelihood is that much of the potential bad news from the earnings is priced into the stock at current levels.
I want to make a defined risk play that the stock bounces on better than expected results. As I indicate in the title of the post, long premium structures on the whole look like a difficult way to make money as the implied vol has been elevated for weeks now, and will most certainly see a substantial decline. In many ways the best trade on the board is likely to sell vol, but we will wait right before the event to identify the proper structure.
With less than two and half trading days to the print, and a long weekend in between, I need to be cognizant of how I choose establish a long premium position. This is where Butterflies come in. If I were back trading at a bank, I would likely choose to buy a 1×2 call spread or a call tree, but because I have to be cognizant of naked short positions and margin, I will look to cover my wings.
I AM PUTTING THIS TRADE ON VERY SMALL, AS I AM RESERVING MY RIGHT (SO TO SPEAK) TO CHANGE STRIKES CLOSER TO THE PRINT.
TRADE: AAPL (~$500) Bought the Jan25th 525 / 550/ 575 Call Butterfly for 3.00
-Bought 1 Jan25th 525 call for 8.80
-Sold 2 Jan25th 550 calls at 7.25 or 3.625 each
-Bought 1 Jan25th 575 call for 1.45
Break-Even on Jan25th Expiration:
-Profits btwn 528 and 572 with max gain of 22.00 at 550.
-Losses of up to 3.00 btwn 525 and 528 and btwn 572 and 575, with max loss of 3.00 below 525 and above 575
Trade Rationale: I like the idea of isolating that 550 strike on the upside as I think the stock could struggle there as it has recently. This trade works well after the announcement on any move higher towards 525 and above, and has enough room to still stay profitable if AAPL surprises everyone and the stock makes a big upside move. If the selling pressure continued in the stock and we saw 400′s after earnings, I’m only risking 3 dollars, something that was worth the shot.
And here’s our webinar from last week:
Webinar Presentation 1/14/13: Anatomy of an AAPL Earnings Trade With Options
Webinar: Anatomy of an AAPL Earnings Trade With Options
The most attractive uses for equity options for the average investor are; Risk Management, Yield Enhancement, and Leverage. In this webinar, we plan to touch on all 3 points. Given that we are just starting earnings season, we thought it may be most useful to touch on how we use equity options to express single stock views around a potentially volatile event such as an earnings report.
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 and qualitative and quantitative approaches and decide not to play.
1. Implied move:
With AAPL at ~$503, the Jan 25th weekly 500 straddle is offered at ~$38, (the Jan 25th 500 call is offered at ~21 and the Jan 25th 500 Put is offered at ~17).
If you bought that straddle you would need a $38 move up or down by Friday Jan25th’s close, that’s ~7.5%, but that’s not the implied move for the earnings event. Embedded in the price today, there are about 10 trading days of time value in the straddle in addition to the “event” time value.
HOW DO WE DETERMINE THE “EVENT” MOVE?
1) If the earnings fall in a week where there are weeklies options, you can pretty much take the at the money straddle price as a decent estimate of the event move.
2) Like in AAPL’s case today, if the event is not this week, we need to back out the one day “event” using our implied move calculator (For a rundown on these calculations please visit our discussion here).
Here is a link to our Implied Move Calculator. The Calculator helps us give an approximate estimation of the priced move the options market if the listed strikes don’t fall close to the spot price of the equity or if there are no weekly options and to get sense for how much of the straddle price is time value.
2. Historical moves:
Now we want to look at AAPL’s historical moves following earning. How does the options market view this report vs the past performance? The spreadsheet screen below shows that the average move over the last 4 quarters has been 5.1% and is 3.9% over the last 8 quarters. The implied move of ~6.4% appears to be a bit expensive compared to historical:
|eps est||reported||% move|
|4 qtr avg||5.1%|
|8 qtr avg||3.93%|
- Fortress balance sheet with over $120 billion in cash, no debt, expected to generate more than ~$10 billion in cash per quarter in fiscal 2013.
- Stock trading at ~10x 2013 expected earnings and 9x 2014. The company has a dividend yield of 2%.
- In the last 4 months, the company has refreshed almost every major product lines as they headed into the all important holiday selling season
- A few potential positive catalysts include AAPL inking a distribution deal with China Mobile (who has 700 million subscribers), expected dividend increases/stock buybacks, and the “white whale” that is AAPL TV.
- Following the product refreshes investors will closely scrutinize the degree of gross margin compression in their key iOS product portfolio.
- As evidenced by the plethora of competitive products recently released at the Consumer Electronics Show last week in Las Vegas, AAPL is being attacked on many fronts, with higher quality products that call into question the company’s ability to continue their past rate of innovation.
- The Law Of Large Numbers may finally be settling in for a company that has shown dramatic growth over such a long period of time.
Enis went through the technicals on AAPL in his Chart of the Day post for Talking Numbers on CNBC. Here is the meat of the post:
1 year chart of AAPL:
I’ve drawn a horizontal red line at the all-important $500 support level. The purple line shows the 50 day moving average, and I’ve highlighted with green circles the 3 times over the past 3 months where the 50 day ma has acted as resistance.
The 50 day moving average is now around the 550 level, which is the main resistance level here as well. While I’m somewhat neutral in this range, my inclination is that AAPL is more likely to break below $500 rather than above $550.
Here’s the tie-breaking chart:
This is a 6 month chart of SPY (orange) vs. AAPL (black), which shows the divergent paths of the two assets since the beginning of December. In my view, if AAPL cannot move higher when the broader stock market has ample demand, then it’s more likely to come under pressure on the slightest hint of weakness in the broader market. In that regard, a break of $500 seems quite possible on the next SPY pullback.
I would get interested on the long side in AAPL if it broke $500 in a panic on capitulation-type selling. Until then, I don’t see a good risk/reward trade in either direction in AAPL at current prices.
Wall Street analysts are fairly Bullish on the stock with 53 Buys, 8 Holds and only 2 Sells with an average 12 month price target of ~$731. Short interest sits at a measly 2% of the float. Sentiment heading into this quarterly report maybe the most negative in recent memory, as analysts have been falling over each other to temper fiscal Q1 estimates and price targets since the October earnings release which disappointed on almost every major metric. To highlight this, the chart below shows the dramatic fall off in Q1 estimates as the company guided below Wall Street consensus (red line = Q1 2013 consensus estimates).
The chart below shows that the 30 day realized volatility (white line) and the 30 day implied volatility (blue line) are both near their 2 year highs, in the 35-40 range. Normally, this would seem like a good area to sell implied volatility overall based on the 2 year history. Options traders have obviously changed their overall view on AAPL’s volatility since the trend changed in the fall. If the stock does stabilize however, implied volatility has quite a bit of room to fall.
The Options Market
Here’s a look at the January 25th options with the stock at ~$503:
And here are the February regulars:
Trades to Consider:
A) NO EXISTING STOCK POSITION
1. Vertical Spreads – Replicate long or short exposure
LONG: Trade: AAPL (~$503) Buy Jan25th 520/ 540 Call Spread for 5.70
- Buy 1 Jan25th 520 calls for 12.10
- Sell 1 Jan25th 540 Calls at 6.40
Break-Even on Jan25th Expiration:
- Profits of up to 14.30 btwn 525.70 and 540, max gain of 14.30 above 540
- Losses of up to 5.70 btwn 520 and 525.70 and max loss of 5.70 below 520
Trade Rationale: If you wanted to make a defined risk bet that the stock would rally in line with the implied move.
SHORT: Trade: AAPL (~$503) Buy Jan25th 480 / 460 Put Spread for 5.60
- Buy 1 Jan25th 480 put for 11.60
- Sell 1 Jan25th 460 put at 6.00
Break-Even on Jan25th Expiration:
- Profits of up to 14.40 btwn 474.60 and 460, max gain of 14.40 below 460
- Losses of up to 5.60 btwn 474.60 and 480, and max loss of 5.60 above 480
Trade Rationale: If you wanted to make a defined risk bet that the stock would sell off in line with the implied move.
2. Sell the Move: You could conclude that the options market is overpricing the potential move in the stock and you could do any of the following.
Trade: AAPL (~$503) Sell the Jan25 weekly 500 straddle at 38.50
- Sell 1 AAPL Jan25th wkly 500 call around 20.60
- Sell 1 AAPL Jan25th wkly 500 Put around 17.90
Break-Even on Jan25th wkly Expiration:
- Profits if the stock is btwn 461.50 and 538.50 you make the difference btwn the premium you sold and the cost of buying back the straddle.
- Losses if the stock is below 461.50 and above 538.50
Trade Rationale Believe it or not, while there is higher risk to selling the straddle as the risk is not defined, there is a higher probability of success, because no matter what happens, vols will come in after the event. And once the defined range is set the options that are set to expire at 4pm will start to decay very quickly and just trade a a few cents over parity=they will trade like stock. The main risk to this trade is that the stock has an out-sized move and you will either be effectively short stock if trading through you call strike
Second Trade Structure: Another way to “sell the move” on earnings is to sell the front month weekly option, and buy a farther out expiry option. This would be buying a calendar.
TRADE: AAPL (~$503) Buy AAPL Jan25th wkly / Feb 500 call calendar for 4.50
- Sell 1 AAPL Jan25th wkly 500 call at 20.70
- Buy 1 AAPL Feb 500 call for 25.20
Break-Even On Jan 25th Expiration:
This is a trade where you are rooting for a small move in either direction (though the ideal scenario is that AAPL closes at 500 on Friday). Why either direction? Suppose AAPL sells off to 490. Then your AAPL Jan25th wkly 500 call will be worthless on Friday Jan 25th expiry. Meanwhile, your Feb 500 call will still hold a good amount of time value, and will be priced above the $4.50 that you paid for the trade.
Now suppose AAPL rallies to 510. The Jan25th 500 call will expire at intrinsic value of $10, and your Feb 500 call will be worth more than $14.50 since the time value of the Feb 500 strike will still be substantial. As a result, the calendar will be worth more than the $4.50 that you paid for it.
Your main risk on this trade structure is that the stock moves a lot. If AAPL closes on Friday Jan 25th around $450, your Jan 25th call will be worthless, but your long Feb 500 call will be worth less than $4.50, as it’s a long shot trade at that point. If AAPL rallied to 550 or above, your Jan 25th call will be worth more than $50 on expiry, and your Feb 500 call will have less than $4.50 in time value since it will be so far away from strike, meaning the calendar is worth less than the $4.50 that you paid.
3. Buy the Move:
First Trade Structure: If you didn’t have a directional bias, but thought the one day move price was too cheap, you could buy the at the money weekly straddle.
TRADE: AAPL (~$503) Buy AAPL Jan25th wkly 500 straddle for 38.50
- Buy 1 AAPL Jan25th wkly 500 call for 20.60
- Buy 1 AAPL Jan25th wkly 500 Put for 17.90
Break-Even On Jan 25th Expiration:
- Profits above 538.50 and below 461.50
- Losses of up to 38.50 if stock btwn 461.50 and 538.50, Max risk of 38.50 if the stock settles exactly at 500
Trade Rationale: You are essentially betting that at some point btwn purchase and Friday Jan 25th on the close that the stock would be below 461.50 or above 538.50, or about 7.75% in either direction.
This is a trade where the likelihood of losing all the premium that you spend is not great as there is a high probability that one of these options will be in the money on Friday Jan 25th and you would have to make a decision to close one leg if the stock does not have an out-sized move. You also have to be cognizant of closing the leg that is in the money or you could be assigned, and if the stock is pinned to the strike you may want to close the whole position to ensure you do not end up with the position you do not want on Monday morning.
Second Trade Structure: Another way to “buy the move” on earnings is to buy the front month weekly option, and sell a farther out expiry option. This would be selling a calendar.
TRADE: AAPL (~$503) Sell AAPL Jan25th wkly / Feb 500 call calendar at 4.50
- Buy 1 AAPL Jan25th 500 call for 20.70
- Sell 1 AAPL Feb 500 call at 25.20
Break-Even On Jan25th Expiration:
This is a trade where you are rooting for a big move in either direction. As I explained above related to buying a calendar, when the stock makes a big move in either direction, the call calendar position loses value. So if you are selling the calendar, your hope is that the stock makes a bigger than expected move on earnings, and you can close out the position on Friday expiration for a gain.
B) AGAINST EXISTING LONG STOCK POSITION
1. Take Advantage of Elevated Implied Vol in Weeklies: Yield Enhancement
In Front of an event To Add Yield and Leverage to an Existing Long Stock Position.
TRADE: Against A Long Stock Position in AAPL (~$503) Buy AAPL Jan25th wkly 510/535 1×2 Call Spread for $1.00
- Buy 1 AAPL Jan25th wkly 510 call for 16.00
- Sell 2 AAPL Jan25th wkly 535 calls at 7.50 for a total of 15.00
Break-Even Jan25th wkly Expiration:
- Profits of the stock above current spot, 503
- Profits of the 1×2 Call Spread btwn 511 and 559, max gain of $24 with stock at 535 on expiry
- If stock is above 535 on Friday Jan 25th’s close, your long stock will be called away at 535, so you have made $32 in the stock from the current level, but you have also made $24 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 503, plus the 1.00 in premium that you paid for the 1×2 call spread.
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 strong possibility of an out-sized move to the upside. You would also have to be comfortable with the fact that your stock could be called up away up essentially 6.5% in 9 trading days. So the cost of the short term leverage (besides the 1.00 in premium) is the fact that you are capping your gains (in the case of this 1×2 example, you lose money on the options structure above 559)
2. Collar Long Stock – Risk Management
TRADE: Against A Long Stock Position in AAPL (~$503) Buy AAPL Jan25th wkly 475/525 Collar, Collect $1.75
- Sell 1 Jan25th 525 call at 10.25
- Buy 1 Jan25th 475 Put for 8.50
Break-Even on Jan25th Expiration:
- Stock Profits btwn 501.25 and 525, stock called away at 525 (up about 5%, slightly shy of the implied move), profits capped up with stock at 525 or higher…
- Losses of up to 26.25 btwn 501.25 and 475, no further losses below 475 (max loss of 26.25 on your long stock position)
Trade Rationale: You would do this against a long stock position if you thought that the potential for a dramatic move lower was greater than a dramatic move higher. This is a perfect structure for longs who are not 100% that the story is over, and want to participate in some further upside, but could not stomach a massive sell off.