Saturday, January 26, 2008

A Credit Spread on Apple Inc. (AAPL)

Dear fellow options traders,

I remember when I started out trading options in 2005 based on earnings gapping, the options premium were not as expensive as of today. The stock options premium could be inflated due to a few reasons, but one of them would be high implied volatility. If a company's share price has been gapping exponentially after earnings announcement for a few consecutive quarters, the market makers would normally priced in this gapping range into the options premium, thus injecting high implied volatility into the premium.

As you might have already known, if you intend to trade a straight call or put option for earnings gapping, you must first predict the anticipated direction correctly, no excuse about that. Secondly, you must pray that the gapping magnitude/scale of the stock price right after company's earnings announcement would be large enough to cover the collapse of implied volatility of the options premium right after earnings announcement. I guess if you have been a premium subscriber of Briefing.com, you would have noticed a news alert entitled "OPTNX Unusual Options Activity" where it would inform you that volatility have decreased for certain stocks which have just reported earnings. So, do remember that options premium price would usually fall right after earnings announcement, due to implied volatility collapse.

But I would definitely discourage you from doing naked options selling even though these options might be a few strike out-the-money (OTM). Although it might seem lucrative to naked sell an option to take advantage of the collapse in implied volatility right after earnings in the hope to buy back the option cheaper afterwards, you would undoubtedly be exposed to unlimited risks! It is especially risky if you're selling naked call options since a company's share price could rise infinitely after a particular event.

Thus this time round, I decided to use a credit spread to trade Apple Inc. (ticker : AAPL) earnings announcement. I've done my research and felt that Apple Inc. should be able to beat Q1 earnings and as usual they should be once again issued conservative guidance for Q2 just like the previous few quarters.

As mentioned earlier, stock options for companies reporting earnings were getting costly and options for Apple Inc. (ticker : AAPL) were no exception. Thus, on 22 Jan 2008, I set up a paper trade bull put credit spread of selling 1 no. of Feb 145 put and buying 1 no. of Feb 140 put for a credit of around $165.00 when AAPL was still trading around $156.00, meaning that the Feb 145 put option that I've sold was a whopping $11.00 out-the-money.

So why a credit spread? You may ask. Well, due to high implied volatility of AAPL stock options, the options premium that could be collected were still attractive although they were a few strikes away. Secondly, the credit spread strategy would be less risky compared to a straight option position since it has 3 situations where it could make money :

1) if the share price went up
2) if the share price stay the same
3) if share price only drop a little

However, if the share price dropped a lot, my credit spread ie. bull put spread would lose money, the maximum loss being the difference of the strike price ie. $500.00 and of course the commissions for setting up the credit spread.

On 22 Jan 2008, Apple Inc. (ticker : AAPL) reported Q1 earnings of $1.76 per share, $0.14 better than consensus of $1.62; revenues rose 35.0% year/year to $9.61 bln vs the $9.47 bln consensus. As expected, the company issued downside guidance for Q2, expecting EPS of $0.94 vs. $1.09 consensus; while Q2 revenues were expected to be 6.8 bln vs. $6.98 bln consensus. But the market reacted negatively to the shortfall in iPod shipments, where the company registered 22.1 mln units vs ~25 mln units street expectation.

On 23 Jan 2008 when market opened, Apple Inc. gapped down by almost -$17.00 to $136.20. As mentioned earlier, my bull put credit spread would lose money if the share price dropped a lot. Thus, I was prepared to lose money in the position. But I understand that if Apple Inc. (ticker : AAPL) share price could go up intra-day, I might be able to close the position with a smaller loss.

Thus, I monitored the stock chart and Level 2 code carefully but once I saw that AAPL has difficulty moving up, I close the position by buying back the Feb 145 put and sold off the Feb 140 put for a loss of $174.00 (The $165.00 credit that I've received earlier for setting up the position helped defray some of the loses).

If I would have bought a straight Feb 165 call which cost $810.00 per contract when AAPL was trading around $155.00, where the call option was almost $10.00 out-the-money but still costs $810.00 per contract, I would have lost more money compared to the credit spread that I had set up.




Thus, in way, the credit spread has helped minimize the loss of more capital if you had committed it in a straight option position in this situation. I hope this would provide you an alternative idea if you intend to trade earnings gapping next time.

Yours Truly,

Tony Chai
Options Trading Resources

Note : On 22 Jan 2008, the Dow Jones Future plunged more than 500 points. The U.S. Federal Reserve quickly moved in to cut a un-precedented 75 basis points to the interest rate in an effort to revive the market. On 23 Jan 2008, the Dow Jones Industrial Average sank as much as 323 points before bouncing back to rise 298.98 points, or 2.5 percent, to 12,270.17.

7 comments:

onglai said...

Hi, thanks for your sharing. definetly I have learn something from your experience. I also still hold the worthless AAPL call 210, bought when the stock price $177. hope it will bounce back, but seems that It will just go south.

thx

gerimegaly said...

Hey Tony, happen to stumble upon your blog...good to meet another fellow S'porean trading the markets. Incidentally, I served my NS from Dec 1986 to Jun 1989

Villager said...

Hi Tony, I think for a volatile stock like AAPL, on earning announcement days, it would be better to administer a straddle, which profit on big gapping, doesn't matter which direction. But of course the risk is that it doesn't gap big enough to profit :) What's your view?

Tony Chai said...

Hi Villager :

Thanks for your comments.

With options (calls & puts) getting costlier for stocks about to announce earnings, putting up a straddle or strangle would be quite expensive.

The stock price would really need to make a big move in either direction to overcome the high implied volatility being injected into the options premium.

If you encounter a few trades which do not gap exponentially after earnings, the capital that you commit to such expensive straddle/strangle trades might be easily depleted.

Regards,

Tony Chai
Options Trading Blog

Tony Chai said...

Hi Gerimegaly :

I met with a hand grenade accident while serving NS in mid Aug 1986. I had just graduated Polytechnic then.

It could be painful when I got stares when they look at my stump but I have to get over it, just like when I overcome bad trades and learn the lessons involved.

I guess the more painful thing is to hear my father cry loudly when I was lying sub-conscious on the hospital bed. I've known him since young to be a stern man and whipped me badly when I'm naughty. In this fateful situation then I realized when I was lying in pain with a lost hand, it pained him hundreds time more to see me in this state.

Most Chinese are usually conservative in the expression of their love to their loved ones. Our parents loved us deeply although they would not say those words explicitly to us.

Treasure & reciprocate their love for us while they are still with us. I cannot give much but I would spend time with them and buy them food whenever I could.

Regards,

Tony Chai
Options Trading Blog

tumez said...

Thanks for your sharing, have you try selling options? Because I only selling options

gerimegaly said...

Thx for sharing in details, as to what happened to you.
In adversity, the human spirit rises to conquer the unthinkable and I believe you have done just that!
I wish you all the very best in your pursuit in trading options...