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).
Volatility’s Impact on Option Prices
Last week, the market (SPY) fell 1%, the second down week in a row. Our 10K Bear portfolio gained 17.8%, after commissions. Over the past two weeks SPY has fallen by 3.4% while this bearish portfolio has gained a whopping 42.6%, proving once again that it is an excellent hedge against other investments when the market is weaker. Do you have this kind of protection in your investment accounts?
Today I would like to talk a little about an important measure in the options world – volatility, and how it affects how much you pay for an option (either put or call).
Volatility’s Impact on Option Prices
Volatility is the sole variable that can only be measured after the option prices are known. All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding. If option trading were a poker game, volatility would be the wild card.
Volatility is the most exciting measure of stock options. Quite simply, option volatility means how much you expect the stock to vary in price. The term “volatility” is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).
When an options trader says “IBM’s at 20%” he is referring to the implied volatility of the front-month at-the-money puts and calls. Some people use the term “projected volatility” rather than “implied volatility.” They mean the same thing.
A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number. For P & G, this number currently is 17%. That is how much the market expects the stock might vary in price, either up or down, over the course of a year.
Here are some volatility numbers for other popular companies:
IBM – 20%
Apple Computer – 31%
GE – 26%
Johnson and Johnson – 16%
Goldman Sachs – 37%
Amazon – 37%
You can see that the degree of stability of the company is reflected in its volatility number. IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated.
Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks. Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index. An ETF such as OIH which is influenced by changes in the price of oil would logically carry a higher volatility number.
Here are some volatility numbers for the options of some popular ETFs:
Dow Jones Industrial (Tracking Stock – DIA) – 19%
S&P 500 (Tracking Stock – SPY) –21%
Nasdaq (Tracking Stock – QQQ) – 20%
Russell 2000 (Small Cap – IWM) – 27%
Oil Services ETF (OIH) – 32%
Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card. It is the most important variable of all.
If implied volatility is high, the option prices are high. If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.
Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.
How Option Prices are Determined
Last week was the worst week for the market in 2012. The S&P 500 fell by 2.4%. We were delighted to see our 10K Bear portfolio gain 24.2% for the week (10 times the percentage loss), once again demonstrating that a properly-executed options portfolio can provide a hedge against other investments that do best when the market moves higher.
This week we will take a step back and review the components that determine the value of an option. These components are the variables in most mathematical models designed to calculate the theoretical value that an option should be trading for, including the most popular Black-Scholes Model.
How Option Prices are Determined
Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices. Usually, they meet somewhere in the middle and a price is determined. This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.
There are 5 components that determine the value of an option:
1. The price of the underlying stock
2. The strike price of the option
3. The time until the option expires
4. The cost of money (interest rates less dividends, if any)
5. The volatility of the underlying stock
The first four components are easy to figure out. Each can precisely be measured. If they were the only components necessary, option pricing would be a no-brainer. Anyone who could add and subtract could figure it out to the penny.
The fifth component – volatility – is the wild card. It is where all the fun starts. Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company. Volatility is absolutely the most important (and elusive) ingredient of option prices.
Volatility is simply a measure of how much the stock fluctuates. So shouldn’t it be easy to figure out? It actually is easy to calculate, if you are content with looking backwards. The amount of fluctuation in the past is called historical volatility. It can be precisely measured, but of course it might be a little different each year.
So historical volatility gives market professionals an idea of what the volatility number should be. However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.
In future newsletters, we’ll continue this discussion of volatility and why it is the most important variable in option pricing.
Andy’s Market Report 5/6/12
The market experienced its worst week of 2012 on the back of a worse than anticipated unemployment report.
The S&P 500 fell 1.6% to 1,369.10, extending its weekly drop to 2.4%. The Dow slumped 168.32 or 1.3%, to 13,038.27 Friday.
Employers added 115,000 jobs in April, the Labor Department stated on Friday. It was the third straight month in which hiring had slowed, intensifying fears the U.S. recovery is truly losing momentum.
In addition, even a slight drop in the unemployment rate to 8.1% had a dark tone because the fall was due entirely to people dropping out of the workforce.
“The bottom line is you don’t have evidence that this economy has reached escape velocity,” said Robert Tipp, an investment strategist at Prudential Fixed Income.
Analysts had expected 170,000 new jobs in April, and the shortfall could open the door a bit wider for the Federal Reserve to step up efforts to help the economy with another round of quantitative easing.
The employment report included another ominous numbers. The participation rate, a measure of how many Americans are looking for work, fell to a 30-year low at 63.6% of the population.
But kicking the can down the road once again isn’t the ultimate answer. The economy is not growing as fast as needed and with continued woes in Europe there could be another rough road ahead. This of course is just speculation, but when stripped down to its core the economy does not look promising over the coming months.
Technical Mumbo Jumbo
The S&P pushed through 1370 and is now on track to hit 1350. If the major market index is able to push through that level I would expect to see a test of the 1290 area. However, I do expect to see a short-term bounce over the near-term only because of the oversold nature of the market. But, once that kicks back into a neutral state which might only take half a trading day, I expect the selling to start back up.
Remember, sell in May is upon us and I expect to see the historical norms to once again play out this year. One of the perks is that volatility as see by the VIX, VXX and VXN should increase which should afford some great opportunities to sell premium.
The economic calendar is light next week, but elections in Europe should stir the market pot during the early part of the week. One thing is certain next week should be very interesting…possibly the most interesting week of the year.