Over the past several weeks, shares of Apple (NASDAQ:AAPL) have been incredibly weak after peaking on the same day the iPhone 5 launched. Trading volume has also been on the rise, likely a contributing factor to the increased volatility the stock has been experiencing.
It seems like every day the iPhone maker has a swing of 1% to 2%. Considering Apple's sheer size, that can translate into market-cap swings in excess of $10 billion -- greater than the entire market cap of many companies. Additionally, it's not like there's any tangible reason for the drop. It's not like the Google (NASDAQ: GOOG) flagship Galaxy Nexus staying on store shelves is a major threat. Oh well, just another day in the life of the largest tech company on Earth.
With shares now down over 10% from the peak and significantly underperforming the broader market while long-term fundamentals remain solidly intact, Apple is definitely a buy in my book.
For opportunistic bulls, simply buying shares is but one way to capitalize on the pullback. But for adventurous investors with an appetite for risk, there is another option.
One of the most important determinants of option pricing is implied volatility, or IV. All else equal, higher IV levels translate into higher options prices across the board, for both calls and puts. It also turns out that Apple's fiscal fourth quarter earnings release is just around the corner on Oct. 25, which will naturally put upwards pressure on IV as we approach that date.
Combined with the actual volatility that Apple shares are experiencing, IV has been steadily rising for the past couple of weeks. Focus on the brown line.
I've already explained why rising IV makes buying options a terrible way to play a volatile earnings season, due to the inevitable drop in IV (marked by green boxes above) that mercilessly brings all prices down. But by that same rationale, selling options can be a great way to play. After all, selling high is half the battle.
Reward, meet risk
Let's run through an example. If an investor were bullish on Apple, then selling a put might be the right strategy. A put with a $600 strike that expires on Jan. 19, 2013, closed on Friday near $29. At 100 shares per standard contract, selling that put would bring in a credit of $2,900.
If shares are under $600 upon expiration, the put seller is required to purchase 100 shares of Apple at $600 for a total cost of $60,000. If shares are above $600 upon expiration, the put expires worthless and the investor realizes a maximum gain of $2,900. The breakeven point on this trade would be the strike price minus the premium received, or $571. The investor loses money if Apple is below $571 upon the January expiration.
In the near term, Apple could potentially "miss" on earnings and shares could fall further, potentially bad news for a put seller. However, let's say that theoretically Apple's earnings come in right on target and the stock doesn't flinch much at all. In that case, IV will still drop precipitously and the price of that put will similarly fall, allowing the investor to buy the put back at a lower price, if one was so inclined. Buying low is the other half of the aforementioned skirmish.
There are any number of specific put contracts out there to choose from, but one reason I like this strategy in general right now is that there are 3 ways to profit:
- IV level drops after earnings.
- Time passes.
- Share price increases.
The beauty here is that sure as you're born, No. 1 and No. 2 will happen. Ideally, shares rally and No. 3 can join the party, but two out of three factors squarely in favor of a put seller are good odds in my book.
Plenty of options
A $60,000 put assignment in the above example can be a lot to stomach, but an investor could even potentially buy a put with a lower strike to create a spread and limit the downside risk (as well as the upside profit potential) and possible capital outlay.
In fact, this strategy could even work for an Apple bear, who would sell calls instead of puts (except selling naked calls is the highest-risk options strategy known to man). As one of the Motley Fool's most unabashed Apple bulls, I think right now is a perfect time to sell puts or a put spread. Not only are the fundamentals of option pricing in favor of such a strategy, but there are two possibly imminent positive catalysts on the horizon: fourth quarter earnings and an iPad Mini unveiling.
Options trading isn't for everyone, but for some this might be the right trade at the right time.
Evan Niu, CFA, owns shares of Apple. The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services recommend 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.