Apple (AAPL) options continue to fascinate me.  Today I would like to discuss a set of calendar spreads designed to capitalize on the escalating AAPL option prices that will come into play when Weeklys which expire just after the January earnings announcement become available. Those Weeklys will come on the scene on the Thursday before the January 2013 options expire the next day.

Check it out.

The Perfect Way to Play the Apple Earnings Announcement

Apple (AAPL) is due to announce earnings on January 22, 2013 (although this is currently unconfirmed). A year ago they announced earnings on Tuesday, January 24, 2012 just after the monthly options expired. The January 22, 2013 date would be consistent with that pattern. Of course, this is the big quarter when iPhone 5 and the iPad Mini results will be known for the first time.

A year ago the market responded favorably to the announcement and the stock moved $26 higher on the news (and then continued to move up more slowly for several months).

Who knows what will happen this time around?  I sure don’t, although I expect it will be higher than it is today.  I have devised a strategy for those of us who really don’t know where Apple will end up a month from now. 
My strategy is fully explained in a Seeking Article I published yesterday –

The Perfect Way to Play the Apple Earnings Announcement

The key thing to remember here is to buy calendar spreads at a variety of strike prices to increase the odds that the stock ends up near one of those strikes during the second half of January.

Happy trading.

Today I would like to share an actual spread I placed in my personal account today.  It is a simple bet that come January 18, 2013, Apple will be trading at some price above $500.  As I write this, AAPL is at $513.

This little bet will make 62% after commissions at any ending price above $500.  It doesn’t have to go up a penny to make this much in a single month.  In fact, it can fall $13 and the same gain will come my way.
Check it out.

An Interesting Bet on Apple

One of the biggest stock market mysteries I have ever experienced in 30 years of trading almost every day has been the recent implosion of Apple stock.  For years, I was on the lookout for companies whose P/E ratio was less than its growth rate.

Two months ago when AAPL was trading north of $700, its growth rate was more than double the P/E ratio (not even adjusting for cash), even taking the traditionally-conservative company projections for next quarter.  Opportunities like this are quite rare in the investment world, at least they have been in the past.

Since that time the stock has fallen nearly $200.  I was not alone in my surprise at such a drop.  The average price target for 48 analysts is $750.  How can so many presumably smart (and well-informed) people be so horribly wrong?  Maybe they aren’t, at least in the longer run.

Trying to catch the bottom of a falling stock has been compared to catching a knife dropped from a great height (with your bare hands, of course).  I must admit that I have made several attempts to catch a bottom over the past two months, and my portfolio value has dropped right along with the stock.  It has been a painful time for us Apple bulls.

But now I think the bottom is finally here.  From a technical standpoint, there seems to be a strong resistance point at $505.  I’m not much of a technical indicator guy, but so many people are that sometimes you just have to follow their lead.  It has come close to $505 a couple of weeks ago, rose sharply, and then retreated to test that level once again last week, and has since recovered a bit.

Much of the recent sell-off has been attributed to tax-related selling.  If a person had a huge gain in the stock (and anyone who has bought it in earlier years surely has), it might be better to sell your shares in 2012 to avoid what looks like a higher long-term capital gains rate that may be instituted in 2013.  Many people are expected the rate to increase from 15% to at least 25% next year.  That would make it a good time to take some profits.

Anyone who sold AAPL for tax reasons probably still likes the stock (after all, it did give them a big win) and may buy it back once they read about millions of new iPhone 5 sales at Christmas and in China (and now, even at Wal-Mart) and anticipate what those sales might mean to earnings.

There are many other reasons that the stock should be trading higher in 2013.  It usually spikes higher in advance of the January earnings announcement which should come just after the January options expire.  When the announcement is made, the P/E ratio will surely be even lower than it is today since this will be the first quarter when the iPhone 5 results are in (the most profitable Apple product, and the biggest problem has been making it fast enough to keep up with the demand).

So here’s the little bet I made that Apple will be trading at some point higher than $500 on January 18, 2013:

I bought AAPL Jan-13 495 puts and sold Jan-13 500 puts, collecting $195 per spread, or $192 after commissions (in options lingo, I sold a vertical put spread).  If the stock closes at any price below $495, I will have to buy the spread back for $500 and I will lose $308 (the maximum risk I am taking).

My broker will issue a maintenance requirement for $500 per spread (this is not a loan like a margin requirement, but $500 per spread will have to be set aside in the account).  Since I collected $192, my actual net charge will be $308.  By the way, this kind of a spread is allowed in IRA accounts at most brokerages, including thinkorswim.

At any price above $500, both options will expire worthless, no commissions will be due, and I will make a gain of $192 on my maximum risk of $308.  That works out to about 62% on my money at risk.  Not bad for one month.

Of course, you should not take this risk with money you can’t afford to lose.

Back spreads and ratio spreads are usually discussed together because they are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread.
Since ratio spreads involve selling “naked” (i.e., uncovered by another long option) they can’t be used in an IRA.  For that reason, and because we like to sleep better at night knowing that we are not naked short and could possibly lose more than our original investment, we do not trade ratio spreads at Terry’s Tips.

Back spreads involve selling one option and buying a greater quantity of an option with a more out-of-the-money strike. The options are either both calls or both puts.
A typical back spread using calls might consist of buying 10 at-the-money calls and selling 5 in-the-money calls at a strike low enough to buy the entire back spread at a credit. 
Ideally, you collect a credit when you set up a back spread.  Since the option you are buying is less expensive than the one you are buying, it is always possible to set up the back spread at a credit.  You would like as many extra long positions as possible to maximize your gains if the underlying makes a big move in the direction you are betting. 
If you are wrong and the underlying moves in the opposite direction that you originally hoped, if you had set up the back spread at a net credit at the beginning, all of your options will expire worthless and you will be able to keep the original credit as pure profit (after paying commissions on the original trades, of course).
Call back spreads work best when the stock price makes a large move up; put back spreads work best when the stock price makes a large move down.
One of the easiest ways to think about a back spread is as a vertical with some extra long options. A call back spread is a bear vertical (typically a short call vertical) plus extra long call options at the higher of the two strikes. A put back spread is a bull vertical (typically a short put vertical) plus extra long put options at the lower of the two strikes.
The purpose of a back spread is to profit on a quick extended move toward, through and beyond the long strike. The purchase of a quantity of more long options is financed by the sale of fewer short options. The danger is that because the short options are usually in the money, they might grow faster than the long out-of-the-money options if the stock price moves more slowly or with less magnitude than expected. This happens even faster as expiration approaches. The long out-of-the-money options may lose value despite a favorable move in the stock price, and that same move in the stock price may increase the value of the short options. This is when the back spread loses value most quickly. This is depicted in the “valley” of the risk profile graphs. The greatest loss in the graph occurs at exactly the strike price of the long options.

There are two reasons that I personally don’t like back spreads.  First, they are negative theta.  That means you lose money on your positions every day that nothing much happens to the underlying strike price. 

Second, and more importantly, the gains you make in the good time periods are inconsequential compared to the large losses you could incur in the other time periods.  If the stock moves in the opposite way you are hoping, you end up making a very small gain (the initial credit you collected when the positions were originally placed).  If the underlying doesn’t move much, your losses could be huge.  On the other hand, in order for you to make large gains when the market moves in the direction you hope it will, the move must be very large before significant gains come about.

Here is the risk profile graph for a back spread on SPY (buying 10 Dec-12 142 calls for $1.55 and selling 6 Dec-12 140 calls for $2.78 when SPY was trading at $142.20 and there were two weeks until expiration):

You have about $1100 at risk (the $1200 maintenance requirement less the $115 credit (after commissions) you collected at the outset.  If the stock falls by more than $2.20 so that all the calls expire worthless, you would gain the $115 credit.  If the stock moves higher by $2, you would lose just about that same amount.  It would have to move $2.20 higher before a gain could be expected on the upside, and every dollar the stock moved higher from there would result in a $400 gain (the number of extra calls you own).

The big problem is that if the stock doesn’t do much of anything, you stand to lose about $1000, a far greater loss than most of the scenarios when a gain could be expected.  In order for you to make $1000 with these positions, the stock would have to go up by $5 in the two-week period.  Of course, that happens once in a great while, but probably less than 10% of the time.  There there is a much greater likelihood of its moving less than $2 in either direction (and a loss would occur at any point within that range).

Bottom line, back spreads might be considered if you have a strong feeling that the underlying stock might move strongly in one direction or another, but I believe that there are other more promising directional strategies such as vertical spreads, calendar or diagonal spreads, or even straddles or strangles that make more sense to me.

This week I wrote an article for Seeking Alpha which describes an option portfolio that bets on VIX moving higher as uncertainty grows over the looming fiscal cliff.  The best part of the deal is that the options will make about a 50% gain even if VIX doesn’t go up a bit over the next three weeks until the options expire.
Please read this important article as it could show you a way to provide extremely good protection against you other investments should the market take a big dive this month.

Black Swan Insurance
Here’s the link:

Black Swan Insurance That Might Pay Off Even If There Is No Crash

This is a very simple strategy that involvBlack Swan Insurance That Might Pay Off Even If There Is No Crashes buying in-the-money Dec-12 13 calls and selling a smaller number of Dec-12 16 calls.  You are setting up a vertical spread for some of the calls and holding several calls uncovered long.  The 13 calls have essentially no time premium in them and the 16 calls have a lot of time premium since they are very close to the money.

The only scenario where these positions lose money is if VIX falls much below 15 when the options expire on December 19.  For its entire history, VIX has traded below 15 on only a few rare occasions, and it always moved higher shortly thereafter.

If VIX does get down close to 15 as expiration nears, additional calls might be sold against the uncovered long calls you own, maybe at the 15 strike..  This would expand the downside break-even range about a half a dollar.

There are a few things that you should know about trading VIX options. Weekly options are not available.  You are restricted to the regular monthly option series.  Even more restricting, calendar spreads and diagonal spreads are not allowed in VIX options because the underlying entity is a derivative rather than an actual stock.  You are pretty much restricted to vertical or back spreads unless you want to post a large maintenance requirement.

In spite of these limitations, VIX options are a lot better than VXX if you want to buy portfolio insurance.  VXX suffers from contango dilution most of the time while VIX fluctuates independent of any such headwinds.

This week we will discuss three investment concepts that you probably never heard of. If you understood them, they might just change your investment returns for the rest of your life.  Surely, it will be worth your time to read about them. 

Contango, Backwardation, and VXX

There seems to be a widespread need for a definition of contango.   I figure that about 99% of investors have no idea of what contango or backwardation are.  That’s a shame, because they are important concepts which can be precisely measured and they strongly influence whether certain investment instruments will move higher (or lower).  Understanding contango and backwardation can seriously improve your chances of making profitable investments.

Contango sounds like it might be some sort of exotic dance that you do against (con) someone, and maybe the definition of backwardation is what your partner does, just the opposite (indeed, it is, but we’re getting a little ahead of ourselves because we haven’t defined contango as yet). 

If you have an idea (in advance) which way a stock or other investment instrument is headed, you have a real edge in deciding what to do.  Contango can give you that edge.

So here’s the definition of contango – it is simply that the prices of futures are upward sloping over time, (second month more expensive than front month, third month more expensive than second, etc.), Usually, the further out in the future you look, the less certain you are about what will happen, and the more uncertainty there is, the higher the futures prices are.  For this reason, contango is the case about 75 – 90% of the time.

Sometimes, when a market crash has occurred or Greece seems to be on the brink of imploding, the short-term outlook is more uncertain than the longer-term outlook (people expect that things will settle down eventually).  When this happens, backwardation is the case – a downward-sloping curve over time. 

So what’s the big deal about the shape of the price curve?  In itself, it doesn’t mean much, but when it gets involved in the construction of some investment instruments, it does become a big deal.

All about VXX

One of the most frequent times that contango appears in the financial press is when VXX is discussed. VXX is an ETN (Exchange Traded Note) which trades very much like any stock.  You can buy (or sell) shares in it, just like you can IBM.  You can also buy or sell options using VXX as the underlying (that’s why it important at Terry’s Tips). 
VXX was created by Barclay’s on January 29, 2009 and it will be closed out with a cash settlement on January 30, 2019 (so we have a few years remaining to play with it).

VXX is an equity that people purchase as protection against a market crash.  It is based on the short-term futures of VIX, the so-called “fear index” which is a measure of the implied volatility of options on SPY, the tracking stock for the S&P 500.  When the market crashes, VIX usually soars, the futures for VIX move higher as well, pushing up the price of VXX.

In August of 2011 when the market (SPY) fell by 10%, VXX rose from $21 to $42, a 100% gain.  Backwardation set in and VXX remained above $40 for several months.  VXX had performed exactly as it was intended to.  Pundits have argued that a $10,000 investment in VXX protects a $100,000 portfolio of stocks against loss in case of a market crash.  No wonder it is so popular.  Investors buy about $3 billion worth of VXX every month as crash protection against their other investments in stocks or mutual funds.

There is only one small bad thing about VXX.  Over the long term, it is just about the worst stock you could ever buy.  Check out its graph since it was first created in January of 2009.

Have you ever seen such a dog?  (Maybe you bought stock in one or two of these, but I suspect no matter how bad they were, they couldn’t match VXX’s performance). On two occasions (November 9, 2010 and October 5, 2012) they had to make 1 – 4 reverse splits to make the stock have a reasonable value.  It never really traded at $2000 as the graph suggests, but two reverse splits will make it seem that way.
VXX is designed to mimic a 30 day futures contract on the VIX spot index (note: the VIX “spot” index is not directly tradable, so short term futures are the nearest proxy). Every day, Barclays VXX “sells” 1/30th of its assets in front month VIX futures contracts and buys second month contracts which are almost always more costly. This is where contango becomes important.
 It’s the old story of “buy high” and “sell low” that so many of us have  done with their stock investments, but Barclays does it every day (don’t feel sorry for them – they are selling VXX, not buying it, and they are making a fortune every month).
There are two other reasons besides contango that VXX is destined to move lower over time. First, when the value of an instrument is based on changes in the value of another measure, a mathematical glitch always occurs.  When VIX is at 20 and increases by 10%, it goes up by 2, and the tracking instrument (VXX) is likely to move by about that percentage in the same direction. If the next day, VIX falls by 10%, it goes down by 2.20 (10% of 22).  At the end of the two-day period, VXX will end up $.20 lower than where it started.

This is the same thing that happens if you lose 50% of the value of a stock investment.  The stock has to go up by 100% for you to get your money back.  In the day-by-day adjusting of the value of VXX based on changes in VIX, the value of VXX gets pushed lower by a tiny amount every day because of the mathematical adjustment mechanism.

A third reason that VXX gets lower in the long run is that Barclay’s charges a 0.89% fee each year to maintain the ETN. 

In summary, because of the predominant condition of contango as well as the way VXX is constructed, it is destined to go down consistently every month.  Coming soon, we will discuss option strategies that can prosper from this phenomenon.

The world of stock options is every changing.  Last week, three new series of options were introduced. Options trades should be aware of these new options, and understand how they might fit into their options strategies, no matter what those  strategies might be.

Three New (Weekly) Options Series Introduced

Last week, the CBOE announced the arrival of several new options series for our favorite ETFs as well as four individual popular stocks which have extremely high options activity.

Here they are:

For the above entities, there are now four Weekly options series available at any given time.  In the past, Weekly options for the following week became available on a Thursday (with eight days of remaining life).

This is a big change for those of us who trade the Weeklys (I know that seems to be a funny way to spell the plural of Weekly, but that is what the CBOE does).  No longer will we have to wait until Thursday to roll over short options to the next week to gain maximum decay (theta) for our short positions.

The stocks and ETFs for which the new Weeklys are available are among the most active options markets out there.  Already, these markets have very small bid-ask spreads (meaning that you can usually get very good executions, often at the mid-point of the bid-ask spread rather than being forced to buy at the ask price and sell at the bid price).  This advantage should extend to the new Weekly series, although I have noticed that the bid-ask spreads are slightly higher for the third and fourth weeks out, at least at this time.

The new Weeklys will particularly be important for Apple.  Option prices have traditionally sky-rocketed for the option series which comes a few days after their quarterly earnings announcements.  In the past, a popular strategy was to place a calendar or diagonal spread in advance of an announcement (further-out options tend to be far less expensive (lower implied volatility) than those expiring shortly after the announcement, and potentially profitable spreads are often available.  The long side had to be the newt monthly series, often a full three weeks later.

With the new Weekly series now being available, extremely inexpensive spreads might be possible, with the long side having only seven days of more time than the Weeklys that you are selling.  It will be very interesting come next January. 

     Bottom line, the new Weekly series will give you far more flexibility in taking a short-term view on stock price movement and/or volatility changes, plus more ways to profit from time decay.  It is good news for all options traders.

A week ago I gave you details on how to use stock options to create the perfect hedge against a market crash.  Last Monday, a mini-crash took place.  It was the worst day for the market all year. While the market (SPY) fell 2.3%, VXX rose 7.6%.  The Crash Control portfolio I set up as a hedge against a crash gained 18%, and is poised to gain at an accelerated rate if the market continues to fall. 

The market totally vindicated my analysis.

First, the high inverse correlation between VXX and the market came true, and the options strategy we set up using VXX as the underlying had a high correlation with the price of VXX.  So when the market tanked, the Crash Control portfolio prospered.

The great thing about this market-hedge options portfolio is that it is designed to make a small profit even if the market doesn’t crash.  It’s like buying insurance and getting a settlement even though the bad event that you bought insurance for didn’t actually happen.

A Timely Test of the Ultimate Hedge Against a Market Crash

The link to the follow-up on the options market hedge strategy is:

A Timely Test of the Ultimate Hedge Against a Market Crash

I suspect you will find this market-crash options strategy is so complex that you would be happier just subscribing to Terry’s Tips, sign up for Auto-Trade, and have thinkorswim execute the trades for you in your account.

Last week just before the Apple earnings announcement after the close on Thursday, I published an article on Seeking Alpha which suggested an options strategy to play prior to the announcement.  Basically, I spoke about taking advantage of the big Implied Volatility advantage for calendar spreads, and placing long-December (IV = 74) short-November (IV = 40) calendar spreads at many strike prices, both below and above the stock price.

Today I would like to offer you a link to the follow-up article also published at Seeking Alpha.

Closing Out The Options Play For The Apple Earnings Announcement

Here is the link:

Closing Out The Options Play For The Apple Earnings Announcement

IV for the December options fell more than we expected after the announcement.  This means that our original projections were too rosy.  We were fortunate enough to make a gain on the strategy nevertheless.   The learning experience was more valuable than the loss or gain.

If you like a stock, there is a much better way to make money on it other than buying shares.  The answer is to use options, of course.  Today I would like to share one simple trade you can make as an alternative to owning the stock.  It should gain over 50% in two months even if the stock does not go up by a penny.  If the stock falls by 10% over that period, you should make about 20%.  Meanwhile, people who bought the stock would have absolutely nothing to show for their investment (except maybe a loss).

Why would you ever buy a share of stock when options could deliver these kinds of returns?

An Interesting Options Play for Green Mountain Coffee Roasters

Green Mountain Coffee Roasters (GMCR) has had a rocky year, but for the last few months it seems to have stabilized and might be worth a second look (especially if you could make 20% or more on it with options in just two months as I propose here).  First, check out a recent Seeking Alpha article Green Mountain: Stock Is A Good Brew.  It might give you a little confidence in the stock.
 
In the interests of presenting both sides, check out the downside case, also at Seeking Alpha – Stay Away From Green Mountain Coffee.  However, even this critic advises against shorting the stock. 

GMCR is selling at 9x or 10x earnings and doesn’t appear likely to have a big sell-off in the near future.  One option investor recently made a huge options bet that the stock will move higher – see Bulls Smell the Coffee at Green Mountain.  These options could return $5 million to the buyer if the stock is above $30 when the November options expire on the 17th.

The option strategy I suggest should make about 20% in two months even if GMCR falls by 10% over that time period.

I have watched this company for many years.  It is located in my home state of Vermont.  I used to play tennis with its founder, Bob Stiller, every week.  (I don’t want to brag, but I remember that I won about 90% of the matches – he seemed to be more interested in growing his company than staying in tennis shape.)   Just today, Bob donated $10 million to Champlain College, a local business school that has also been one of my favorite charities (and where I was a trustee for 11 years).

Here is what the risk profile graph looks like for the stock (currently trading at just under $24).  These positions cost about $2700 to put on:

The graph shows that a nice profit averaging over 30% can be made in two months at any ending price on December 21st which is higher than $22, and a profit of some sort at any price higher than $20.50.  This downside break-even point would mean that the stock fell by 14% from its current level.

Here are the actual positions that create the above risk profile graph:

I used 10 diagonal call spreads, buying January 2013 calls and selling December 23 calls for about $2.70 ($270 per spread).  This simple trade is far superior to owning the stock as far as I am concerned.  If the stock falls 10%, you still make about 20% on your investment.  If the stock stays exactly where it is on January 18th you should earn almost 60% on your money.

Why would anyone buy the stock when they could place a simple spread like this and make money even if the stock goes nowhere or even falls by as much as 10%?  It just doesn’t make sense to me.

—-

Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.   Why wait any longer to make this important investment in yourself?

I have submitted an article to Seeking Alpha that I would like to share with you.

How to Play Google Options Post-Earnings

Here’s the link – Google Post-Earnings Option Strategy

This strategy will gain 20% in 60 days as long as Google (GOOG) doesn’t fall by more than $50 during that time.  The 20% should come if GOOG falls by $50, remains flat, or moves higher by any amount. Once earnings are announced, the stock usually quiets down a bit, making this strategy an attractive one, at least if you are bullish on Google. 

A properly-devised options strategy can protect you against a $50 drop in the price while leaving you plenty of room to prosper if the stock continues to rise over time.

Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.   Why wait any longer to make this important investment in yourself?

I look forward to having you on board, and to prospering with you.

Terry