To profit from Apple’s earnings report this Wednesday, we are going to create a strangle using out-of-the-money options.
|Date||Estimate||Actual||Close Pre Earnings||Close Post Earnings||Percent Change|
Simply put, I am making this trade based on history. Nothing more, nothing less.
Historically, Apple stock exhibits volatile and large price movements following it’s earnings releases. In fact, four out of the last five earnings reports have resulted in price movements of at least four percent. With that being said, it is not unreasonable to anticipate a significant price movement following Apple’s earnings report this Wednesday. In order to take advantage of this, we can employ a basic strangle using out-of-the-money options that will allow us to profit from a significant price movement, regardless of direction. A strangle also limits the loss of the position to the net cost.
|Price Call||Strike||Price Put|
To successfully create a strangle, we need to take long positions in an out-of-the-money call and an out-of-the-money put. It is recommended that the strike prices of these out-of-the-money options be equidistant from the current price of the underlying instrument, which in this case is Apple common stock. The further out of the money the options are the cheaper it will be to establish the strangle and the smaller our max loss per contract will be. However, the further out of the money the options are, they less likely the strangle will expire in the money.
Currently, the price of the underlying Apple common stock is exactly $500.00 (Cool, I know). Using the January weeklys, which will expire this coming Friday (January 25th, 2012), I am going to take a long position in a call with a strike price of $510.00 and a put with a strike price of $490.00. These options are priced at a per contract cost of $13.35 and $13.05, respectively. Since we are taking a long position in both the out-of-the-money call and the out-of-the-money put, our net per contract cost is equal $26.40. Options contracts are usually denominated in terms of 100 shares meaning the absolute net per contract cost of this strangle is $2640.
Profit/Loss & Break-even:
When using a strangle, there are two break even points. Ignoring the cost of commissions, there is a break even point below the strike price of the out-of-the-money put (B1) and above the out-of-the-money call(B2). B2 can be calculated by subtracting the per contract cost from the strike price of the out-of-the-money put. B1 can be calculated by adding the per contract cost to the strike price of the out-of-the-money call. In this particular example we can calculate B1 by subtracting $26.40 from $490, giving us a break even point of $463.60. Similarly, we can calculate B2 by adding $26.40 to $510, giving us a break even point of $536.40.
Scenario 1: Max Loss
As I mentioned before, my max loss per contract is limited to the absolute cost of the contract. In this particular setup, my max loss is $2640.00. I will experience this max loss if the price of the underlying at expiration is between the strike price of the put and the call. Specifically, I will experience this max loss if the price of the underlying at expiration is between $490.00 and $510.00. In my opinion, this is not likely but could happen if Apple reports earnings consistent with estimates, no misses or beats.
Scenario 2: Loss
If the underlying price change of Apple is not big enough following Apple’s earnings report, I will experience a loss less then my max loss at expiration. This can happen if the price of the underlying is in one of two ranges. The first range is if the underlying price closes below the strike price of the out-of-the-money put, but above b1. Similarly, the second range is if the underlying stock price closes above the strike price of the out-of-the-money call, but below b2. The loss in these situations is equal to difference between the price of the underlying at the sale and the strike price, plus the cost of the contract.
For example, lets say the price of the underlying Apple stock is $520.00 at expiration. Since I am long the $510.00 January weekly, I will be able to buy 100 shares of Apple at $510.00 and sell them on the open market at $520. This means I will make a profit of $10.00 per share. Even though I profit on the sale of the Apple shares on the open market, I am still responsible for the cost of the contract, which is $26.40 per share. This leaves my net loss at $16.40 per share, or $1640.00. As you will notice, this is still a loss but is less then my max loss.
Scenario 3: Profit
This is the most desirable and most likely scenario in my opinion. There are two situations in which I will experience a profit. The first is if the underlying Apple Stock price at expiration is below B1, and the second is if the underlying Apple stock price at expiration is above B2. In the first situation, I will be able to sell the underlying shares higher then market price. In the second situation, I will be able to sell the shares at a higher then market price. If the underlying stock price when I exercise is less then B1, the Profit will be equal to the difference between B1 and the price of the underlying at expiration, minus the per contract cost of the strangle. If the price underlying Apple stock price when I exercise is above B2, the profit will be equal to the different in the underlying price at expiration minus B2, minus the per contract cost.
For example, lets pretend that the price of the underlying Apple stock at expiration is $545.00.Since we are long the $510.00 January weekly, we will be able to buy the underlying at $510.00 and sell at the market price of $545.00. Since we paid $26.40 for the strangle, our per share profit will be $8.60 ($860.00).