Two Ways to Play Apple (AAPL) Earnings

Apple AAPL stock and the company’s product line are both definitely favorites of mine. If you have followed my writing any amount of time, you’ll know that the smartphone universe and the players within it have been under my microscope for almost two years now. Apple, of course, is more than a smartphone company, but its number-one product is the iPhone, so many analysts tend to put great emphasis on sales of that product. Even with strong iPhone sales, the other products do certainly play a role and we will want to see growth across the entire product line.

The iPhone 4 was released this past quarter and the bulk of the new iPads (3G and variants) sales will be included in this quarter’s earnings as well. Now that we are about three months past the iPad’s April 3 release, data on this device’s sales will also be key.

Based on anecdotal evidence and a statement from Apple, iPhone 4 was a record breaker in new product sales. Obviously there is the antenna issue with this product, but Apple is applying a band-aid in the form of a free case for everyone who bought the phone.

Even though some think Steve Jobs’ tone was almost “condescending” in his conference on Friday to address the issue, the equity market made its own decision and the stock actually held its ground among a sharply declining broader market. But given reports that the iPhone 4 drops twice as many calls as its predecessor, future sales are certainly a concern, as are costs to the company and a permanent solution to the issue.

Coming into its Tuesday earnings report, Apple has some serious expectations behind it. According to several sources, the consensus second-quarter earnings expectation is about $3.10 per share, up from $2.01 a year ago. Most are looking for a revenue increase of about 76.8% to $14.7 billion year over year.

Apple has a tendency to play down its future expectations and is typically quite reserved with any commentary it makes to that end. They do, however, have a history of beating the Street’s estimates. In fact, Apple has exceeded analysts’ expectations for the past five quarters, sometimes by as much as 76%.

Since hitting almost $280.00 on June 21, Apple has given back about $30, or roughly 11%. For the most part, Apple has managed to close above its 50-day simple moving average for the past nine-plus months. The majority of analysts that cover the stock have it rated as a buy with some price targets into the $300 dollar range. But some traders are fearful that this iPhone 4 debacle could have longer-lasting ramifications. In this unique situation, options traders may employ spread strategies to take advantage of reduced risk, limited reward, and theoretically higher probability.

Implied volatility for front-month options is elevated at 43% versus the 30 -day observed volatility, which stands at about 29% going into the report. It is typical, but not guaranteed, that implied volatility tends to come in (move lower) right after an earnings report, barring any catastrophic news or a statement by the company that creates immense uncertainly after the event.

Now, even though volatility may come in after the report is disseminated, the stock may have still moved +- 5% (for example), which could equate to a +- $12 in the stock and could potentially have negative repercussions on certain strategies. A 43% implied volatility suggests a daily standard deviation of about 2.7% by the way.

So even though many options traders may tend to lean more towards a “short vega” strategy ahead of an earnings report, you still need to consider the potential dollar moves that a stock may make over the report when choosing a strategy and strikes.

For investors who believe that Apple will hold its 200-day moving average of $222 by August expiration and want to express a bearish sentiment on volatility, a credit ratio put spread can be examined. The ratio put spread involves the purchase of one put and the simultaneous sale of two lower-strike puts. For this to be a credit spread, the sale of the two puts must bring in more cash (combined) than the debit paid for the long put.

For example, for investors believing that Apple might drop to $222.00 or close to it, buying the August 230 put and selling two August 220 puts can be done for a credit of $2.00. Even though this is a credit trade, the ratio put spread does allow for a greater profit than the credit brought in at the onset in this case. In fact, the maximum profit potential of $12.00 would be achieved if Apple was trading right at $220 on August expiration.

In a 10-point spread like this example, investors could potentially make 10 dollars on the bear put spread (the difference between the strikes) and get to keep the $1.20 credit for selling the spread initially. (The ratio put spread is essentially a bear put vertical financed with a naked short put).

The risk to this trade is basically the short strike minus the spread width (10 points) minus the credit received ($2.00), which means the downside breakeven and maximum risk are both $208.00 (should Apple fall all the way to zero by August 20 – not likely!).

In this trade, which I know is a bit more complex, Apple stock could go all the way down to $208.00 by August expiration and investors could potentially break even (excluding commissions). Anywhere above this level is potential profit. Most importantly, because this trade was done for a credit, Apple stock could rise to infinity and you would still retain your credit of $2.00 per spread. Note that margin would be required in this trade because of the naked short put.

This strategy is short 27 vega per spread, which means if implied volatility were to come in 10 absolute percentage points, you could theoretically see a $270.00 profit, roughly, per spread. Of course, if volatility continues to rise, the position will be negatively impacted.

Apple (AAPL) ratio put spread

This is not the only way to express a moderately bearish view, and those bullish on Apple could consider a simple vertical spread (such as selling the August 230/220 bull put spread) for $2.15. The maximum profit for this spread is $2.15 (the credit received) while the risk is limited to $7.85 (the difference between the strikes minus the credit received).

This trade would be profitable if AAPL stock stays above $230 by August expiration and also expresses a moderately bearish view on volatility. Breakeven is the short strike minus the credit received, or $227.85. Maximum loss occurs when the stock price is at $220 or below. When it comes to trading a stock around earnings time, remember there are always options… :-)

Photo Credit: Karl Baron

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