Big Profits in Apple With Less Risk

Apple (Nasdaq: AAPL  ) has become the most valuable company among its peers, easily surpassing Microsoft (Nasdaq: MSFT  ) , Cisco Systems (Nasdaq: CSCO  ) , and Intel (Nasdaq: INTC  ) -- making it the second most valuable company in the world. But even so, Apple's amazing growth story is still young. Following a 52% jump in revenue last year, Apple looks ripe to enjoy strong revenue growth for at least the next few years, too.

The company is a driving force behind a hurricane of change as the world embraces mobile technology. Research firm IDC expects the mobile-computer industry to grow unit shipments by a strong 22% in 2011, 19% in 2012, and 17% in 2013. Gartner Research estimates that smartphones accounted for just 19.3% of worldwide mobile phone shipments near the end of 2010. About 200 million smartphones were sold through the first three quarters of 2010, but more than double that number -- at least 500 million -- could ship annually by 2015. Then there's the tablet market. From perhaps 15 million sold in 2010, tablets could reach annual unit sales as high as 57 million in 2015, according to ABI Research.

So although the world has been singing Apple's praises for years, it doesn't take a genius to divine that the company still faces many years of growth ahead of it. As mobile computing takes the world by storm, Apple has the leading products, a jump on the competition, untapped markets -- as the Verizon (NYSE: VZ  ) deal demonstrates -- and budding network effects (including app stores and iTunes, the world's biggest music retailer) to help it stay on top. 

And the share price has much less fire than the company's famous CEO. Recently sitting at $344, Apple trades at 17 times expected earnings per share for the year ending September 2011 -- and about 15 times earnings when you subtract Apple's cash and investment cache. But we need to admit that the stock isn't likely to double again anytime soon; investors buying today are putting down a lot of capital probably just in hopes of 20% or 30% gains the next few years. Using a strategy that we employ in Motley Fool Pro, you could do much better than that this year -- and profit with less risk, too.

Smart options for strong profit
Rather than shell out $34,000 for every 100 shares of Apple you want to buy, and then settle for maybe a 30% gain down the road, you could use options to set up bull call spreads, spend much less, and generate higher returns on investment even if the stock goes nowhere. With a bull call spread, you buy calls on Apple (which is a bullish position) and then write (or sell) calls at a higher price, too. The two options "cover" each other, so you don't need any margin or extra cash to hold this trade open -- only the initial cost, which can be low. If Apple simply ends above the strike price of your written calls, you earn the full potential profit. This method is best demonstrated by real-life examples:

Apple share price: $344
January 2012 bull call spreads:

Defensive

Buy January 2012 $270 calls @ $91 ($9,100 each)
Write January 2012 $300 calls @ $69 ($6,900 each)
Net cost: $2,200 per spread
Potential return: $780 per spread, or 35% return on capital
Breakeven: $292
Full loss: Below $270
Full profit: Above $300
Stock gain needed for full profit: Apple needs to lose no more than 12.7%

With a defensive spread, you earn a 35% return as long as Apple stays above $300 by next January -- and you need to put up only $2,200 for every 100 shares. The downside: You lose your investment if Apple ends the January 2012 expiration below $270 and you haven't closed your position early. The stock is 21.5% above that worst-case price.

Moderate
Buy January 2012 $300 calls @ $70 ($7,000 each)
Write January 2012 $330 calls @ $52 ($5,200 each)
Net cost: $1,800 per spread
Potential return: $1,200 per spread, or 66% return on capital
Breakeven: $318
Full loss: Below $300
Full profit: Above $330
Stock gain needed for full profit: Apple needs to lose no more than 4%

In the above case, you just need Apple to not lose more than 4% and you'll still gain a 66% return on investment, with a breakeven price of $318. The last two examples are more aggressive, but they don't require a miracle from the stock, either:

More assertive
Buy January 2012 $350 calls @ $42 ($4,200 each)
Write January 2012 $380 calls @ $30 ($3,000 each)
Net cost: $1,200 per spread
Potential return: $1,800 per spread, or 150% return on capital
Break-even: $362
Full loss: Below $350
Full profit: Above $380
Stock gain needed for full profit: 10.4%

Aggressive
Buy January 2012 $380 calls @ $30 ($3,000 each)
Write January 2012 $410 calls @ $22 ($2,200 each)
Net cost: $800 per spread
Potential return: $2,200 per spread, or 263% return on capital
Break-even: $388
Full loss: Below $380
Full profit: Above $410
Stock gain needed for full profit: 19.1%

With a spread, your maximum profit is the difference between your two strike prices, minus the cost to set up the trade. Of course, you can choose any distance between strike prices you like; I found $30 reasonable. Your maximum loss occurs if the stock ends below the lower strike; your maximum profit is earned when the stock is higher than the higher strike. Using much less capital, you can earn higher returns on investment using spreads on stocks you believe in. Consider the tech titans I mentioned earlier:

Microsoft bull call spread; share price $28.50
Buy January 2012 $25 calls @ $4.80 ($480 each)
Write January 2012 $30 calls @ $2 ($200 each)
Net cost: $280 per spread
Potential return: $220 per spread, or 78% return on capital
Breakeven: $27.80
Full loss: Below $25
Full profit: Above $30
Stock gain needed for full profit: 5.2%

Cisco Systems bull call spread; share price $21.15
Buy January 2013 $20 calls @ $4.30 ($430 each)
Write Janaury 2013 $25 calls @ $2.15 ($215 each)
Net cost: $215 per spread
Potential return: $285 per spread, or 132% return on capital
Breakeven: $22.15
Full loss: Below $20
Full profit: Above $25
Stock gain needed for full profit: 18.2%

Intel bull call spread; share price $21.30
Buy January 2013 $20 calls @ $3.50 ($350 each)
Write January 2013 $25 calls @ $1.60 ($160 each)
Net cost: $190 per spread
Potential return: $310 per spread, or 163% return on capital
Breakeven: $21.90
Full loss: Below $20
Full profit: Above $25
Stock gain needed for full profit: 17.3%

You can see how you need relatively modest moves in the stocks over the next one to two years to earn large returns on your investment. This is just one strategy Motley Fool Pro uses (and teaches to members) to make its portfolio go further. On Tuesday, Jan. 18, we're opening the service for just a few days to a small number of new members for the first time since last June. If you'd like to learn more about how Pro can help you regularly profit, simply enter your email address in the box below.

Jeff Fischer is the advisor for Motley Fool Pro and Motley Fool Options. He owns shares of Intel and Apple. Intel and Microsoft are Motley Fool Inside Value recommendations. Apple is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended buying calls on Intel and has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple and Microsoft. Motley Fool Alpha owns shares of Cisco Systems. We Fools don't 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.


Read/Post Comments (4) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2011, at 7:19 PM, jamesd56 wrote:

    No doubt the worst investment advice i have ever seen in 54 years.

    You are completely clueless.

  • Report this Comment On January 15, 2011, at 10:14 PM, Blueman1000 wrote:

    Hey jamesd56, I'm a novice independent investor, tell me why you think the advice above is worthless. I actually learn more from reading the points and counter points in the discussions versus these so called experts.

    Thanks

  • Report this Comment On January 16, 2011, at 9:29 PM, TMFFischer wrote:

    Excellent -- you always learn something from those who disagree. Spreads are standard strategies to earn a strong return on capital with capped risk; please let us know why you dislike the column so much. No need to be hostile, though; you'll be listened to a bit more if you're respectful. --Jeff (investing since 1987 -- completely clueless? show me! I'm listening! :))

  • Report this Comment On January 19, 2011, at 2:01 PM, zavrel wrote:

    Great article, thank you for the inspiration!

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