Apples’ options

Nothing that has occurred concerning Apple (AAPL) since my previous post in April has radically changed my view. The shareholder friendly proposals announced at the last quarterly call and the updates announced  at the recent conference don’t alter the fundamentals. Reduced margins and revenue growth from the flagship iPhone product lines may be partially offset by iPad growth and service revenues (from the likes of iRadio) but Apple’s trajectory is now looking like it’s status as a growth stock is in the past. In short, I think AAPL will trade within a range around +/-20% of its current level until its medium term future is more certain. I don’t see much of a compelling investment case in the short term as I do not think that the market has yet fully grasped the new reality for Apple (e.g. analyst targets still look too rosy to me). I think Apple’s future lies in reinforcing its ecosystem through upgrades, new services and incremental changes to product offerings. New product offerings may restore Apple’s growth status but nothing currently being speculated on seems to be a game changer to me.

I did have a quick look at Apples’ options for opportunities. I used data from Yahoo last weekend at $430 AAPL (I would caution against using data from sources like Yahoo for detailed analysis but they are generally okay for a rough initial feel), as per the graph below (click to enlarge).

Apples optionsGiven the recent volatility in the stock and the current uncertainty, it was no surprise to find that Apple’s options are expensive with significant time decay premia. The option curves are skewed on the upside which reflects current market expectations and doesn’t offer any normal distribution mispricing opportunities.  My analysis show that Apple’s balance sheet limits the downside potential beyond a 30% drop. I was thinking of a possible strategy along the lines of buying the stock and using the dividend to put downside protection but the curve shows that would provide for only a 6 month put at a strike around $360 – not a strategy that is compelling given my views and lack of conviction on the stock.

I do use options occasionally, primarily for two reasons – for risk management purposes (mainly insurance on downsides) or as an investment on a stock by way of an out of the money option that I think will breakout of a historically range (generally on upside but equally valid for downside punt also).  For the latter purpose, the difficulty is finding a liquid out of the money option market over 12 months on such breakout opportunities. Many people follow strategies such as selling puts or calls to supplement returns, such as the one in this article on Apple. I really don’t get these strategies (negative gamma in trader speak). Why take such downside (albeit tail) risk for such little upside? Seems like the ultimate pennies in front of a steamroller play to me. Add in the negative liquidity impacts of the strategy in a stress scenario (just when liquidity becomes so valuable) highlights further the dangers. In the words of the prop trader interviewed in “Inside the House of Money”, Steven Drobny’s excellent book, “you should never be short gamma“.

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