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Using a Vertical Call Spread to Bet on Apple

For the second straight week, six of the eight portfolios carried out at Terry’s Tips gained last week, and the average of all eight portfolios was a whopping 16% gain.  Each week, after commissions.  Where else other than options can you enjoy returns like this?

Today I would like to discuss one of my favorite option spreads if you like a particular stock.  I like Apple, and have recently placed the spread discussed today in my personal account.

Using a Vertical Call Spread to Bet on Apple

I think there are about a dozen reasons why Apple (AAPL) will be trading at a higher price next January than it is right now.  First of all, in spite of growing at about 80% a year, it sells at a lower p/e ratio than the average company in the S&P 500.  Second, the company’s last earnings exceeded analyst expectations by a wide margin (year-to-year growth of about 90%) yet the company is trading at a lower price than before the announcement.  Fundamentally, the stock is clearly undervalued. But the real story is in what is likely to happen over the next six months or so.  Look at this list of possibilities:

1)    A dividend will be made in July for the first time ever.  As soon as it is declared, many big mutual funds (whose charter does not allow them to buy companies which do not pay a dividend) will finally be able to buy shares (and they most certainly will).
2)    A pre-announced $10 billion stock buy-back will start in January.
3)    The iPhone 5 will be available before Christmas.  Many analysts believe that this will be the biggest new product introduction of any company in 2012.
4)    A revolutionary interactive iTelevision product is rumored to be coming, with an announcement possible as early as June (at the same technology conference where Steve Jobs often announced new products).
5)    The company is rumored to be offering a new way of paying for most everything with a mobile device (as is becoming the norm in Europe).  You will be able to pay tolls or get Coke from a vending machine with your cell phone. With an installed base of 200 million iPhones, they seem to be in an excellent position to become the PayPal of mobile devices (which may explain why they are sitting on much of their $100-billion cash hoard rather than distributing it to stockholders).  
6)    They apparently still can’t make iPhones in China fast enough to satisfy the demand, and the largest Chinese telephone company has not yet been allowed to offer the phone to its customers.

And the list goes on.  I think it is highly likely that AAPL will be selling for significantly more next January than it is right now.  So how do I use options to bet on a higher stock price?

I generally do not like to buy calls, or puts, when I believe the market or a particular stock is headed in a certain direction.  Buying an option is putting your money on a depreciating asset.  If the underlying doesn’t move the way you want it to, your investment goes down in value every day.

Rather than buying a call on a stock that you believe is headed higher, you might consider buying a vertical spread.  A vertical spread is simply the purchase of an option and simultaneous sale of another option at different strike prices in the same expiration month (same underlying security, of course).  A vertical spread is a known as a directional spread because it makes or loses money depending on which direction the underlying security takes.

Here is what I did with AAPL.  I bought the January 2013 530 calls and sold the January 2013 580 calls for $25 ($2500 per spread) last week when the stock was trading about $562 (Friday’s close).  If AAPL is trading above $580 in January as I expect it will, this spread will be worth $50, and I will double my money in about seven months.

The downside of buying a vertical spread is that if you are right and the underlying moves in the direction you had hoped, your gain will be limited by the strike prices of your long and short positions.  No matter how high AAPL goes by next January, this spread will never be worth more than $50.

However, the neat thing about vertical spreads is that if the stock doesn’t move at all, you might just make a gain.  With this spread, if the stock is trading exactly where it is today ($562), my investment will be worth $3200, or $700 more than I paid for it, making about 28%, and the stock hasn’t gone up a penny.

Most people would be delighted if they made 28% on their money in a year.  Here is an opportunity to make that much in seven months even if you are wrong (for betting that it will move higher).

Vertical spreads are just another reason why I love options.

Bottom line, buying a vertical spread lowers your potential loss and also lowers the potential gain.  In most instances, I prefer buying a vertical spread to the outright purchase of puts or calls.  In the above example, I would gladly trade the benefit of making 28% if I am wrong and the underlying didn’t change in value with the limited gain I could make if I were right (I’m not a greedy guy – I will be happy with a 100% gain for seven months). 

Of course, if I am totally wrong and the stock moves dramatically lower, I could lose my entire investment.  Just like I could do if I bought any stock or option.  You have to be willing to take a little risk to make a big reward.  I am comfortable enough with Apple’s prospects to take this risk (in fact, I own vertical spreads on AAPL at many other strike prices and expiration months as well).

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