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An Apple Trade to Benefit From Recent Volatility

An Apple Trade to Benefit From Recent Volatility

Apple (Nasdaq: AAPL) came under pressure after Wall Street analysts began lowering their outlook for the company. With AAPL trading above $150 last week, an analyst at Pacific Crest issued an unusual negative note on the company and downgraded the iPhone maker from Overweight to Sector Weight. The analyst noted potential upside from the new iPhone 8 already appears to be priced in to the stock, even before a release date has been announced. The note told clients, “we believe investors are anticipating an extremely strong iPhone 8 cycle, while giving relatively little weight to risks around gross margins, elasticity, supply issues, or the likelihood for declines beyond the iPhone 8 cycle. This reduces the risk/reward ratio and prompts us to downgrade our rating to Sector Weight.”

Pacific Crest’s price target for AAPL is now $145.

Negativity continued on Friday when Mizuho downgraded the stock and cut its price target. That analyst noted, “We are downgrading Apple to Neutral from Buy while adjusting our PT to $150 from $160. The stock has meaningfully outperformed on a year to date basis and we believe enthusiasm around the upcoming product cycle is fully captured at current levels, with limited upside to estimates from here on out. Our sensitivity work indicates bull case earnings per share (EPS) of around $11 which, along with a cycle-peak multiple, indicates limited upside to the stock. As such, we move to the sidelines despite our expectations of a strong iPhone 8 cycle.”

On Monday, Citi joined in the downgrade cycle. That analysts lowered his September estimates for iPhone units, total revenues and EPS. Specifically, Citi has cut September iPhone unit estimates to 40 million while December unit estimates increased to 89 million. This compares with the current consensus estimates of 47 million and 83 million respectively. This drives Citi’s EPS estimates to $8.55 for this year, down from an earlier estimate of $9.00 prior and below the Wall Street consensus estimate of $8.94.

Citi is not completely bearish. They raised next year’s estimate for EPS to $10.92, up slightly from their earlier estimate of $10.60 and well above the consensus estimate of $10.53. The reason for Citi’s cautiousness, “based on industry-wide checks, we believe the significant enhancements to the iPhone 8 [display] could experience delays as it ramps to high volume production in order to meet strong demand.”

The intraday chart of AAPL shows that traders are following the guidance of analysts for now and selling.

AAPL is now at a seven week low in price and is deeply oversold on a technical basis. On a fundamental basis, assuming AAPL meets Citi’s below average estimate for earnings of $8.55, the stock is trading with a price to earnings ratio of about 17 based on this year’s estimate. That is a reasonable valuation and it is likely AAPL could bounce from this level.

There are a number of bullish options strategies that could benefit from an expected bounce. The most appealing, based on the market prices of options, could be a bullish put credit spread. This strategy will involve selling a put and limiting the risk with a spread, earning a credit in the process.

Selling over the past two days has led to a sharp increase in volatility for the stock. Volatility is an important factor in options pricing models and tends to increase when prices fall as it did in this case. This has resulted in put options soaring for AAPL. To profit from that, we can sell puts.

Selling a put is a bullish trade. The put increases in value when the stock price falls. That means put buyers gain when prices fall and the sellers of those puts face losses. On the other hand, if the stock price rises, the put buyers face losses while the put sellers earn a profit.

When selling a put, the maximum gain is limited to the premium collected when the trade is opened.

One advantage to selling a put is that the trade will require less capital than the purchase of the stock. A put sell will usually require capital equal to about 20% of the put exercise price. This means you can benefit from a rally in the stock with just one fifth of the capital required to purchase the stock.

The loss can be large. If the stock price falls below the put option’s exercise price, the seller will be required to buy shares at the exercise price. This can result in significant losses for naked put selling. To reduce the risk, a spread can be created. This involves buying a put option that will allow the seller to limit the size of the potential loss. Rather than address the theory of the trade, we will look at the specifics.

AAPL closed on Monday at $145.32. The June 23 $141 put option is trading at $1.10. This is contract that expires on June 23 with an exercise price of $141. Selling the put will generate immediate income of $110 since each contract covers 100 shares. That will be a credit to your account. Your broker will require that you have capital of at least $2,820 (20% of the exercise price times 100 shares) to open the trade. The credit provides a return of 3.9% on the required capital for a trade that will be open for less than two weeks.

The put is worth nothing if shares of AAPL are trading above $141 at expiration. They will be worth the difference between the stock’s price and the exercise price of $141 if AAPL is below $141 at expiration. For example, at $140, the put option would be worth $1.

If AAPL is above $141, the profit on this trade would be $1.10. Selling the put option will result in a loss if AAPL closes below $139.90 on June 23 If AAPL is between $141 and $139.90, the profit will decrease by the amount AAPL is below $141, the option’s exercise price. Below $139.90, the size of the loss will be equal to the difference the stock price and the breakeven price of $139.90. For example, at $135, the loss would be $4.90.

To limit the loss, we can create a spread. For AAPL, the June 23 $135 put is trading at about $0.40. To create a spread, buy this put. It will cost $40 since each contract covers 100 shares. This will reduce the credit to your account by $40. Selling the $141 put and buying the $135 put will result in immediate income of $60. However, your broker will most likely require a minimum amount of capital equal to the difference between the two put exercise prices or $600 in this trade. This means the return on the required minimum amount of capital will be 10% for a trade with limited risk that will be open for less than two weeks.

The risk on the trade is limited to the difference between the option exercise prices minus the credit you receive when the trade is opened. For this trade that is $600 which is the difference between $141 and $135 minus $60 which is the credit received or $540. The $60 credit is equal to 11.1% of the amount risked.

The probability of success on this trade is relatively high. Based on an options pricing model there is an 73% probability AAPL will be above $141 when these options expire.

Spreads like this offer a way to participate in bullish trends of high priced stocks for investors with limited capital. The risks, potential rewards and probability of success are all known in advance. Traders can adjust the options used in the trade to meet their personal circumstances and risk profile.