An Apple Income Play

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

When a stock falls by a large amount fairly quickly, option premiums tend to become inflated. Coupled with an earnings release, premiums can become stratospheric. Apple (NASDAQ: AAPL), whose stock was once on a seemingly never-ending upward trajectory, has seen its market capitalization fall by about 28% since September of last year. And with earnings set to be released on Jan. 23, some extremely lucrative option plays have formed.

Reasons To Like Apple

Although a lot of doom and gloom is surrounding Apple these days, the company is highly profitable. With $43.95 per share of free cash flow in fiscal 2012 and $128 per share of cash on the books, a stock price of $500 seems outrageously cheap. It's true that growth will be significantly slower than in the past, but at the current valuation it doesn't really matter.

Reasons To Avoid Apple

Apple derives a large portion of their sales from the iPhone, a product which is currently facing a barrage of devices running Google's (NASDAQ: GOOG) Android operating system. When the iPhone first launched there was no other smart phone that could compare. Now, high-end Android devices offer a compelling alternative. Apple will have a tough time maintaining margins faced with so much competition. And without Steve Jobs, true innovation at Apple may be a thing of the past.

This trend of Android claiming more and more market share can be seen below.

<img src="/media/images/user_13886/smartphone_large.png" />

Android's market share went from almost nothing in 2009 to around 70% by the end of 2012. There's the real risk that Apple's market position will become similar to its PC market position: high-end expensive products claiming only a small fraction of the total market. By giving away Android Google allows for extremely inexpensive phones to be made, phones which should dominate in countries with lower per-capita income. At the same time, high-end Android phones can stand toe-to-toe with the iPhone in terms of features. Although there was recently talk of a low-cost iPhone, this prospect seems unlikely.

Since Google makes no money directly from Android phones this is more of an argument against Apple than for Google. However, having a very large user base will potentially allow Google to make a lot of money from app sales. Developers will favor the Android platform simply due to the sheer number of users and may start to shun the iPhone. This is all bad news for Apple.

Selling Puts

One fairly conservative method of generating income is by selling out-of-the-money put options. By selling put options with a strike price below the current share price you give yourself protection against a drop in the share price. You won't be forced to buy shares unless the price falls by a predetermined amount, and you can always buy back the put option instead.

Let's look at the Feb 2013 options, expiring in 31 days as of this writing. They're short enough to keep our annualized returns high, while long enough to allow the stock to recover from any earnings-related snafu.

<table> <thead> <tr><th>Strike</th><th>Premium</th><th>Return</th><th>Annualized Return</th><th>Buffer</th></tr> </thead> <tbody> <tr> <td>$430</td> <td>$3.00</td> <td>0.698%</td> <td>8.215%</td> <td>14%</td> </tr> <tr> <td>$440</td> <td>$4.30</td> <td>0.977%</td> <td>11.507%</td> <td>12%</td> </tr> <tr> <td>$450</td> <td>$6.05</td> <td>1.344%</td> <td>15.830%</td> <td>10%</td> </tr> <tr> <td>$460</td> <td>$8.35</td> <td>1.815%</td> <td>21.373%</td> <td>8%</td> </tr> <tr> <td>$470</td> <td>$11.20</td> <td>2.383%</td> <td>28.058%</td> <td>6%</td> </tr> <tr> <td>$475</td> <td>$12.85</td> <td>2.705%</td> <td>31.852%</td> <td>5%</td> </tr> <tr> <td>$480</td> <td>$14.75</td> <td>3.073%</td> <td>36.181%</td> <td>4%</td> </tr> <tr> <td>$490</td> <td>$18.90</td> <td>3.857%</td> <td>45.415%</td> <td>2%</td> </tr> </tbody> </table>

Since premiums can change rapidly, these numbers may not reflect the current values

If you're extremely bullish on Apple and think that the company will beat earnings estimates but would still like a small buffer against a price decline, then the $490 strike is a good bet. You get a ~2% buffer and an annualized return of 45.415% if the stock doesn't fall below the strike price. That's 3.857% in just 31 days.

Of course, as you increase the buffer size you decrease the return, but a good middle-ground is the $450 strike. The buffer is 10%, so the stock has to fall by a fairly significant amount before problems arise. Along with the large buffer you get an annualized return of 15.83% if the stock price stays above the strike price. A 1.344% return in 31 days is solid. And if the stock rises on better-than-expected earnings it’s possible that you could buy the option back at a lower price and achieve an even better annualized return.

The Bottom Line

Selling put options near an earnings release allows you to claim exceptionally high premiums. Even a fairly large buffer allows for high returns with Apple. I would recommend selling the $450 put option and getting an annualized return of over 15%. The stock would have to fall by 10% before you would have to buy the shares, and even if it did you'd be buying the stock at a price 35% lower than the 52-week high of $700 per share. It's a win-win.

TheBargainBin has no position in any stocks mentioned. 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!

blog comments powered by Disqus