Today I would like to share with you an options investment I made yesterday, just prior to the Apple (AAPL) earnings announcement. While it is too late to make this same investment yourself, you might consider it three months from now when announcement time comes around again, or with another company that you feel good about.

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Terry

 

An AAPL Earnings-Announcement Strategy: Approximately every 90 days, most public companies announce their latest quarterly earnings. Just before the announcement day, things get interesting with option prices. Since stocks often make big moves in either direction once earnings (and other numbers such as gross sales, margins, and future guidance) are announced, option prices get quite expensive, both for puts and for calls.

For people who like to collect high option premiums (i.e., selling expensive options to someone else), this pre-announcement period seems like a great opportunity provided I have a feeling one way or the other about the company. I had a good feeling about AAPL this month. I wasn’t sure what earnings might be (beware of anyone who says he is sure), but I thought the company was fairly priced, and I think the huge stash of cash they are sitting on provides some protection against a large drop in the stock price.

When a situation like this occurs (where I like a company and earnings are about to be announced), one of my favorite strategies is to buy a deep in-the-money call on the company, a call that has a few months of remaining life, and sell an at-the-money call in the shortest-term option series that expires after the announcement day.

On Monday morning, AAPL was trading about $525. I bought a diagonal spread, buying Jan-14 470 calls and selling Nov1-13 525 calls (AAPL has weekly options available, and the Nov1-13 calls would expire on Friday, November 1st , four days after the announcement after the close on Monday.

I paid $62.67 for the Jan-14 470 call and sold the Nov1-13 525 call for $17.28, shelling out a net $45.39 ($4539) for each spread. (Commissions on this trade at thinkorswim were $2.50). The intrinsic value of this spread was $55 (the difference between 525 and 470) which means if the stock moved higher, no matter how high it went, it would always be worth a minimum of $55, or almost $10 above what I paid for it. Since the Jan-14 calls had almost three more months of remaining life than the Nov1-13 calls I sold, they would be worth more (probably at least $5 more) than the intrinsic value when I planned to sell them on Friday.

So I knew that no matter how much the stock were to move higher, I was guaranteed a gain on Friday. If the stock managed to stay right at $525 and the Nov-1 525 call expired worthless (or I had to buy it back for a minimal amount), I stood to gain the entire $17.28 I had collected less a little that the Jan-14 call might decay in four days. A flat market would net me about a 36% gain on my investment, and any higher price for AAPL would result in at least a 25% gain.

After a company makes its announcement, all option prices tend to fall, especially in the shortest-term series that expires just after the announcement. However, deep in-the-money options like the one I bought derive most of their value from being so deep in the money, and they generally do not fall nearly as much as shorter-term, nearer-the-money options.

On the downside, the stock could fall at least $20 before I would incur a loss. Since the delta of the Jan-14 470 call was 80, if the stock fell $20, my long call might fall about $16 ($20 x .80). That would still be less than the $17.28 I collected from the 525 which would expire worthless so I would still make a gain.

Actually, as the stock falls in value, delta for an in-the-money call gets lower, and the Jan-14 call would fall by less than $16. The stock could probably go down at least $25 before I lost money with my original spread.

In the event that AAPL fell over $25 so I lost some money on the spread, since I like the company and it is now trading for only $500, I might want to hang onto my 470 call rather than selling it on Friday. I might sell another 525 (or other strike) call with a few weeks of remaining life, reducing my initial investment by that amount.

I like to make an investment that could make 25% or more in a single week if a company I like stays flat or goes higher by any amount after an announcement, and the stock can fall about 10% and I still make a gain. A more conservative investment would be to sell an in-the-money call rather than an at-the-money call. While the potential maximum gain would be less, you could handle a much greater drop in the stock value before you entered loss territory on the downside.

Two weeks ago I told you about an options investment I made in Google.  This investment was made just before Google was scheduled to announce their earnings for the latest quarter.  For that reason, the October options had skyrocketed in value as they usually do just prior to an announcement, especially the options that will expire shortly after the announcement is made.Google announced earnings after the close on Thursday, October 17th, and the company exceeded expectations by a large margin.  The stock rose over $120 on Friday.

I had made my investment in hopes that it would at least stay flat.  If it did, I would stand to gain about 8% on my investment in only two weeks.  Let’s see how these options did when the stock made such a huge upward swing.

Terry
 
Update on Google Options Purchase:  My original goal was to use call options as a proxy for owning 100 shares of stock.  I discovered that I could buy the equivalent of 100 shares and shell out only $15,500 rather than the $87,000 it would take to buy 100 shares.

As I reported two weeks ago, I bought 2 GOOG 800 calls that expire on the third Friday of January 2014, paying $8600 for each call, or $17,200 in total.

The reason that I bought such deep in-the-money calls is that most of the value was in the intrinsic value of the option rather than the time premium.  Deep in-the-money options don’t carry such a high Implied Volatility as at-the-money options, especially those which expire shortly after an earnings announcement.  That means the calls that I bought were “cheaper” than the October 2013 calls I intended to sell (using my January 2014 800 calls as security).

Since I owned 2 call options at a low strike price I was entitled to use them as collateral to sell someone else the opportunity to buy shares of GOOG at a higher price.  I sold one Oct-13 890 call, collecting $13.50 ($1350) and one Oct-13 935 for $3.50 ($350). 

These option positions gave me the equivalent of 100 shares of GOOG at a cost of $17,200 less the $1700 I collected from selling the two calls, or $15,500.

This was the risk profile graph for my positions that I showed two weeks ago:

Unfortunately, the graph did not extend up to the $1000+ level that the stock moved to, so I will share how I closed out the positions.  When the stock was trading just about $1000 on Friday, I sold one diagonal spread (buying to close the October 2013 890 call and selling to close the January 800 call) and collected $92 ($9200).  That spread had cost me $7250 to buy ($8600 – $1350) so my gain was $1950.  (All these numbers have been rounded to the nearest $50.)

The second diagonal spread (buying to close the October 2013 935 call and selling to close the January 800 call) was sold for $137 ($13,700).  This spread had cost me $8250 ($8600 – $350) so my gain was $5450, giving me a total gain of $7400 on an investment of $15,500, or 47%.

The stock had gone up by 13% and my option portfolio had gained 47%.  How can anyone not love options?

My total commissions on these trades amounted to $10 at the commission rate that thinkorswim offers to Terry’s Tips subscribers.

This is just one example of how I use options to buy the equivalent number of shares of a company I like, and how I can collect a “dividend” each month even if the stock doesn’t actually pay a dividend.  In this case, the stock skyrocketed, and my returns were considerably greater.

Way back when Google (GOOG) went public at $80 a share, I decided that I would like to own 100 shares and hang on to it for the long run. Obviously, that was a good idea as the stock is trading today at $870. My $8000 investment would now be worth $87,000 if I had been able to keep my original shares. Unfortunately, over the years, an options opportunity inevitably came along that looked more attractive to me than my 100 shares of GOOG, and I sold my shares to take advantage of the opportunity.

Many times my investment account had compiled a little spare cash, and I went back into the market and bought more shares of GOOG, always paying a little more to buy it back. At some point it felt like I just had too much money tied up in it. An $8000 commitment is one thing, but $87,000 is real money.

Today I would like to share how I own the equivalent of 100 shares of GOOG for an investment of only $17,000, and the neat thing about my investment is that I get expect to get a “dividend” in the next two weeks of about $1300 if the stock just sits there and doesn’t go anywhere.

I own options, of course. Here is what I own.

Terry

 How to Own 100 Shares of Google for $16,000:  You would have to shell out about $87,000 today to buy 100 shares of GOOG stock. If you bought it on margin, you might have to come up with about half that amount, $43,500, but you have to shell out interest on the margin loan each month. I like money coming in, not going out.

A couple of weeks in this newsletter we talked about the Greek measure delta. This is simple the equivalent number of shares of stock that an option has. I own GOOG 800 calls that expire on the third Friday of January 2014. You could buy one today for $8600. I own 2 of them for a cost of about $17,200.

The delta for these Jan-14 800 calls is 75. That means if the stock goes up by a dollar, the value of each of my options will go up by $75. With these 2 options I own the equivalent of 150 shares of stock.

Since all options decline a little bit every day that the stock stays flat (it is called decay), simply owning options is just about as bad as paying margin interest on a stock loan. As I said earlier, I like money coming in rather than going out.

Since I own 2 call options at a lower strike price that the market price I am entitled to use them as collateral to sell someone else the opportunity to buy shares of GOOG at a higher price. I sold one Oct-13 890 call, collecting $13.50 ($1350) at today’s price. This option will expire in two weeks (October 18). If the stock is at any price less than $890, this call will expire worthless and I will get to keep the entire $1350.

This Oct-13 890 call option that I sold carries a delta of 38, making my net option value 112 deltas (the equivalent of 112 shares of stock).

Since I am aiming to own 100 shares of GOOG, I sold another Oct-13 call, this one at the 935 strike. At today’s prices, this one would go for $3.50 ($350). The delta on this call is 13, reducing my net delta value to exactly 100.

I now own the equivalent of 100 shares of GOOG at a cost of $17,200 less the $1700 I collected from selling the two calls, or $15,500.

The neat thing about my option positions is that if the stock doesn’t go up (as I hope it will), my disappointment will be soothed a bit because I will gain about $1300 over the next two weeks. Here is the risk profile graph for my positions:

The P/L Day column in the lower right-hand corner shows what the gain or loss will be at the price in the first column on the left. (The stock popped up about $3 while I was writing this Monday morning so it is no longer trading at $870 as it was when I started).

There are two disadvantages to owing the options I do rather than the stock. If the stock falls 10%, I will lose about $9800. If I owned 100 shares of stock, I would lose only $8700. On the other hand, if the stock goes up by 10% in the next two weeks, I would only gain $7100 vs. the $8700 I would make if I owned the stock. I don’t think the stock will move by anywhere near these amounts in the next two weeks, so I am content to live with the slightly less I might gain (or the slightly more I would lose) at these extremes.