Avoiding an Apple Overreaction

Photo of Dr Greg Mulhauser
Photo by SuperFantastic - http://flic.kr/p/6RA8tE

Investors who wrote the Apple puts I suggested in April can either lock in their gains now or await further gains at August expiry. The catch? Waiting for further gains introduces extra risk from the possibility of a market overreaction following earnings next week.

I have no particular reason to believe that Apple’s (AAPL) results will disappoint when the company reports earnings next week on 23 July, and barring any major and unforeseen revelations, it’s unlikely that many investors interested in Apple for the longer term will change their views of the company much one way or the other as a result of the earnings report. But the bigger question for investors who might have used my suggestion to write puts at the August 420 strike (“Follow-Up After a Successful Naked Put Write on Apple Prior to Earnings”) is not so much the longer term relevance of one earnings report, but the much shorter term impact of any potential market overreaction on the price of the puts. Since the mainstream media and broader investment community have repeatedly demonstrated a propensity for wild overreactions, both positive and negative, toward the company, put writers face a choice: should investors take all or some of the profit generated so far, or stick it out with any volatility between now and August expiry with a view to gaining even more?

When I suggested the August 420 put, it was going for just under $30. With Apple common stock now at just under $434 and the put at around $8.50, this yields a gain of just under 20% (relative to the margin requirement) in the less than three months since April. The option currently has implied volatility only around 30%, so these options are not yet showing the kind of pricing pressure that sometimes appears very shortly before earnings: if an investor were looking to close this position partially or entirely, now would be the time to do so.

Alternatively, the investor could await August expiry, in which case a close above $420 would yield the maximum profit of just under $3000 per contract, or around 27%. In other words, for waiting roughly an additional month, the put writer would see their maximum gain rising by 35% more, or 7% in absolute terms. As it happens, 7% per month is quite close to what the put writer has already been receiving, but the main difference is that earnings and the market’s potential overreactions to those earnings stand between now and the realization of that final 7% of profit. That final 7% profit comes with a significant risk of losing some or all the gains achieved so far.

As I described earlier this week (“On the Right Side of Irrational”), there are times when even though an investor might be convinced they are correct, it may still be preferable to protect oneself against the much louder voice of the market’s decision temporarily to say otherwise. While some market participants are convinced that Verizon’s (VZ) announcement of 3.8 million iPhone activations in the June quarter will mean big upside for Apple when it reports next week, I’m not so sure. Fortunately, no investor needs to be sure, provided they have structured their positions correctly — and taken profits when it is prudent to do so.

NOTE: While prepping a photo for this article not long after the market open, the price of Apple common stock dropped a few points and the put rose by nearly $1.50; I’ve left the original prices intact from the time the article was originally written rather than updating them to reflect the prices that were current after finishing with the photo.

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