On Friday we initiated a trade in AAPL that took advantage of several factors in the recent action of the stock. Because the trade is influenced by so many different factors, alot of which are somewhat counter-intuitive I thought it would be a great trade to highlight for educational purposes. First, here’s the trade again:
TRADE: AAPL ($541 ) Bought AAPL DEC 570/600 1×2 Call Spread for .70
-Bought 1 Dec 570 Call for 13.90
-Sold 2 Dec 600 Calls for a total of 13.20 or 6.60 each
The imbalanced nature of this trade makes for interesting greeks involved and I want to highlight those, but first I want to touch on the rational for the trade idea. Here was what Dan wrote on the initial trade post:
TRADE RATIONALE: While we are strongly in the camp that the days of AAPL’s parabolic moves are over, we think there is a distinct possibility that there is one more run this year left in the stock, probably back to what should serve as fairly decent resistance at $600. The set up looks fairly decent here, as the company has recently come under significant scrutiny from a whole host of issues ranging from their recent results and guidance, product mishaps and availability, management shake-up, and general questioning of their ability to keep innovating at the same pace of the last 10 years. For all of those reasons we think the stock will likely be range bound for a year or 2, but at this point we want to make a relatively defined risk bet (risk above $630 that I become short) that the stock makes a near term bounce and move back to what we think may be the high end of the range going forward.
So what we were doing was making a slightly bullish bet. But with a structure that is actually short deltas. Let me explain. During its recent downward move AAPL vol has popped to levels it generally doesn’t see except in earnings cycles. This allowed us to put on a trade that was taking advantage of high relative volatility as well as a residual skew to the upside from the sharp downward move. By selling 2 of the higher strike calls we set up a situation where we could be profitable in the trade whether the stock went up, went sideways, or even went down slightly in the time leading to expiration. At expiration the stock must be above 570.70 in order to be profitable, but between now and then it can be profitable in many different scenarios.
The main reason we timed the trade to a point where we thought AAPL stock may find a bottom is how the inputs would change if the stock did start to bottom. The most obvious is what’s happened in vol and skew since we initiated the trade. When we put the trade on Friday, the structure was about a -4 or -5 delta, as the -x2 of the 600 calls were 4 or 5 deltas more than the +1 of the 570 strike. Today, the spread clocks in at about -1 total, a change of 3 or 4 deltas. And with the stock essentially unchanged from where we put on the trade, the spread that we bought for .70 is now worth about 1.70, or a one dollar gain.
That change in delta is representative of the vol coming in in Dec as well as the upside skew becoming more favorable. So now what are we rooting for? The best thing that could happen in the stock is for it to base here, and even better start to creep upward towards our long strike. Because if the stock does base here, and even starts to go higher, the same thing that worked over the weekend will continue to work. Vol will go lower and the skew will become even more favorable. The risks are a gap or series of gaps higher over our short strike (not gonna happen) or a complete breakdown in the stock which would see the strikes lose their premium and the spread go to zero. But even with the stock going down slightly in the next days or weeks, the spread should hold its value. Here’s a risk/payout chart showing the position on Dec 5th with no change in volatility. At the bottom you can see the changes with changes in volatility represented numerically:
As you can see our best scenarios at a point before December expiration are up near our long strike. A move down in the stock doesn’t make the trade a loser for a little bit, with a more substantial move down near 500 hurting the structure more.
At expiration our best scenario is at or below the short strike, at which point the trade would be a home-run as the long strike would be at max value with the short strike options expiring worthless.
So to sum up, the structure has numerous ways to win, and only a few ways to lose, and with such little premium committed, has a great risk reward set-up.