A recent commentator discussed the short and medium term outlooks for the market, and referenced Apple (AAPL) and the S&P in particular. The basic thesis was that in the short term the market could go up, but within six months, a drop of around 20% or more was to be expected. The recommendation was for sitting on the sidelines until this happened so the investor could re-enter on the pull-back and get a better price.
The commentator pointed out that making 10% to even 30% in the short term wasn’t worth the risk of losing it and more, when an inevitable market pull-back arrived. After all, the pull-back could start as early as next week or as late as six months.
I don’t know if this will come to pass or not. The commentator had “studied the charts”, looked at macro issues, and concluded this as inevitable. I take no issue with the thesis, but certainly think the recommendation can be improved upon. To me, sitting out is never the right thing to do. It’s not eating food because you fear food poisoning. You may avoid food poisoning but you starve to death instead.
In my previous articles I have stressed that the first step in any option strategy is to develop a thesis about the market or a particular stock. Once the thesis is developed, pick an option strategy to capitalize on the thesis. Here lies a perfect example of a thesis that we can work with.
So, let’s assume we concur that the short term may show some gains for AAPL, but a better price lies in the offing, within six months. Do we sit out and wait for the pullback?
Keeping this in mind, I’ll craft a strategy for AAPL that will make reasonable gains if there is no pullback, while allowing a true buy-in if it does pull-back. The first step in any option strategy is picking the expiration dates. Since the thesis is for a pull-back within six months, I’ll go with the July 2012 expiration.
The next step is to select the appropriate strategy.! AAPL i s currently trading right around $400. One at-the-money option contract controls 100 shares, and therefore $40,000 in AAPL value. Option contracts don’t trade in partial contracts, so this is the minimum “theoretical investment”. Since I want a dual goal of making gains if the pullback doesn't occur and only buying in if it does occur, I choose a hybrid of two strategies. I “marry” a Put Spread with a Ratio Spread. Here’s how it works:
Leg 1: SELL ONE July 2012 put at the $400 strike. This strike sells for $46.15 per contract and will credit $4,615.
Leg 2: BUY ONE July 2012 protective put at a strike of $355. This strike is picked by subtracting the previous leg option contract price from the strike price ($400 minus $46.15). The cost per contract is $27.60 for a total cost of $2,760.
Leg 3: SELL TWO July 2012 puts at a strike of $310. This strike is picked so that the credit from this leg offsets the cost of the protective put purchased in Leg 2. Each contract credits $14.50, so the total credit is $2,900.
Combining the three legs results in a net credit of $4,755 ($4,615 minus $2,760 plus $2,900). Now, what is the result of all this?
First, if AAPL doesn’t pull back below $400 by expiry the combined credit of $4,755 represents pure profit. This represents a 12% gain on the “theoretical investment”. Not bad if the thesis turns out wrong. Certainly better than “sitting out”.
Second, if AAPL falls below $400, the $4,755 potential profit is slowly given back. But, any initial loss is capped by the $355 protective put. I show no actual loss until the Leg 3 puts at $310 are reached. This corresponds to more than a 20% pull-back. However, at this point the loss is based upon TWO options and a “theoretical investment” of $62,000 (Two contracts at $310).
This chart details the total results:
Price! Points< /b> | P/L |
200.00 | -$21,745.00 |
250.00 | -$11,745.00 |
300.00 | -$1,745.00 |
308.10 | $0.00 |
375.00 | $2,244.07 |
400.00 | $4,744.07 |
400.13 | $4,755.00 |
If the thesis is correct and a 20% pull back occurs, nothing is lost. If the pull-back never comes, the “theoretical investment” earns potentially as much as 12%. If the pull-back is greater than 20%, well, I’ve bought in at around $310.
In evaluating leg 3, $310 buy-in risk, I just ask myself if I’d be willing to buy in at that price, anyway? If the answer is yes, then my downside risk is zero! What if I wasn’t willing to buy at a 20% pull-back but was willing to buy at a greater pull-back? Well, I simply adjust the strikes of each leg down to meet this parameter. The offset is a smaller profit.
In conclusion, once a thesis is developed a strategy can be sought after that will capitalize on the thesis. In this example, I choose to illustrate a strategy for buying on a pull-back, yet allowing some gains if it never arrives.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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