Apple: Is Selling Puts The Right Trade?

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) is currently trading at $520.74, down 0.53% on the day.  The 30 day implied volatility is 39 which is up slight thus far in Friday's trading session.

Apple has been on an incredible run over the past 52 weeks. It has gone from a low of 374.36 to a high of 701.86. It has had great earnings reports and also ones that disappointed. In light of Apple's recent move down, many investors are wondering what's next for Apple. Let's start by understanding some of the contributing factors to Apple's recent downturn.

Fundamentals

Apple has had some serious problems of late which started with the most recent earnings report on October 25. Going into to the earnings event, Apple had a price of $616 and it sold off after the report and has continued to sell off since. Investors weren't pleased with the sales numbers or future prospects.

In addition, the company has had issues lately with its newest flagship product, the iPhone 5. Believe it or not, the company wasn't able to meet the demand for the product. Many consumers went to their website and stores trying to purchase the phone and were turned away. With the iPhone making up over half of Apple's revenues, investors and traders have clearly spotted a problem.

Apple's next earnings date is scheduled for January 22, 2013, which will fall during the February expiration cycle. Wall Street analysts have lofty expectations. Right now the expectations are for $192 billion in sales, which is more than 20% from the same period a year ago. And even more than hitting the overall sales numbers, analysts will be closely examining each business segment, especially iPhone sales, in light of Apple's recent struggles.

All of these mistakes, problems, and hesitations have contributed to volatility going through the roof which we will examine below.

Volatility

Above is a 2 year chart of Apple's 30 and 60 day implied volatility. Most recently, the volatility is starting to spike up and approach near 2 year highs. What does this mean for the investor? Higher implied volatility means that the market is forecasting larger than normal swings in prices for the future.

Above is a 2 year chart of Apple's 10 and 20 day historical volatility.  It is apparent that Apple has become much more volatile in recent trading sessions.  

It is clear that Apple volatility is not only moving higher than usual but is predicted to be higher than normal going forward, as shown in the implied volatility chart above.  Let's take a look at the skew chart for Apple so that we can see how each expiration cycle is pricing their options.



The green line represents the option skew for the week of January 25 which also has the earnings event.  As expected, the skew is much higher for that term as investors are expecting the earnings event to cause a lot of volatility.  The further you go out, the lower the skew is.  Basically this means, that the options are expected to be more volatile near-term rather than in the further terms.  

The point of all this volatility discussion has been to show that Apple is currently more volatile than historically, and the future is expected to be more volatile as well.  This causes the option premiums to be more expensive which can be a benefit to option sellers, as long as they have the correct understanding.  Let's now discuss why selling puts in Apple might be the right move.

Reason For Optimism

Still there are a few reasons to be positive. Apple is a leading innovator of new products and has typically found a way to astound even the most optimistic of analysts. Over the past 5 years, Apple has grown at an annual rate of 65%. Additionally, with the recent sell-off, Apple's 2013 P/E ratio has fallen to 10. This is much lower than Google (NASDAQ: GOOG) which has a PE ratio of 23.  Although Google's Android has captured over 60% of the smart phone market, Apple still has a much more compelling valuation.

Apple also has roughly $130 cash per share available. This is in part why some investors were surprised that a special cash dividend wasn't paid towards the end of 2012, in light of the possible tax hikes that are forthcoming. Nonetheless, the company does have plenty of cash on hand which can be used for future technological developments, which the company is constantly focused on.

Lastly, demand for Apple products has never been higher. Demand was clearly strong for the iPhone5, and since Apple wasn't able to meet that demand earlier this year, perhaps Apple can meet that demand in the near future.

What's the Point of Selling Puts

A good rule of thumb is to sell puts in stocks that you wouldn't mind owning for the long-term and here is why. If you sell a put and that put finishes in the money at expiration, you will be assigned 100 shares of stock for every put that was sold. That means that you will then own 100 shares of stock. In Apple, this can be an expensive trade as 100 shares of stock at the current Apple price would be a net investment of roughly $52,000.

Still I've laid out a few reasons why this might be a good idea. First, there are a number of reasons to be optimistic about Apple's price going forward. This is absolutely necessary for a put selling strategy since getting assigned the stock is a very real possibility. Second, volatility is elevated in Apple which means that a trader will collect more premium than usual to sell an option, or specifically, a put.

The Trade

Technically, Apple hasn't traded below 500 since February 16, 2012. Although the increase in volatility makes that very possible, I would bet against it. Apple is scheduled to release its next earnings on January 22, 2013, which falls during the January 25th weekly expiration cycle. Typically, I would be against selling naked puts during an earnings cycle, but I think Apple has already suffered a strong sell off based on fundamental reasons, that the earnings event is already priced into the stock at this point.

I will be selling the January 25, 2013 500 strike puts for 11.15. Currently the bid is 11.00 but a trader should be able to easily get filled for at least a dime off the bid. For each put that is sold, a trader will collect $1,115. A trader is making the bet that Apple will stay above $488.85 by the end of the expiration period. Ideally, the share price would close above $500 and then the entire premium will be collected as a profit. But even if the stock drops below the $500 level, substantial profits can still be captured as long as the stock price is above $488.85.

The trade does carry some associated risks. Selling naked puts is one of the riskiest trades a trader can put on. The maximum loss of the trade is $48,885 should the stock price go to 0. Although that seems extreme, a more real risk is that poor earnings are not priced into the stock and the stock sees significant weakness after the earnings report.  This could result in significant losses for the trader.

Still I am betting on a strong earnings report and even if the report is negative, I've laid out why I wouldn't mind owning the stock at $500.


Fool Blogger Michael Meyer does not own any positions in any of the companies mentioned in this entry.  All readers interested in trading options should consult their financial advisor to determine suitability of the strategy.  Trading options can result in significant losses, including total loss of account value. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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