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Options Theory: Eating a Rotten Apple

January 3, 2019

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The magical fruit is rotting. But we’re going to eat it anyway. I’ll have to mix-in some options to make the meal tasty enough, but I think we can come up with something both palatable and profitable.

Last night Apple issued lower revenue guidance ahead of its forthcoming earnings report. These type of pre-announcements are rare and unscheduled, so there’s no warning ahead of time that big news is looming and thus a volatile price move is imminent. If you’re an Apple shareholder, my condolences over this morning’s -10% sucker punch.

With the overnight thrashing AAPL stock’s bear market losses have extended to 39%. For comparison, the stock fell 61% during the 2008 financial fiasco. Were it to experience a similar such demolition it would descend to around $92. Currently, it’s at $142. Not that I think it will, by the way. Say what you will about the current economic environment, you doomsayer, but it isn’t anything close to ’08. I use the comparison simply to paint a disaster scenario to ballpark just how low it would take the stock.

In situations such as this, where a cash-flush large-cap beauty has been brought low, where fear is flying and shareholders are dying, I like to trot out the old Fade the Fear trade.

The idea is to start selling puts or put spreads in anticipation that the fear is overblown, that AAPL won’t fall as far as expected over the coming weeks. For example, if you think AAPL won’t fall below $115 over the next 43 days, you could sell the Feb $115 puts for around $1.00.

Think of it this way. You’re betting that the 39% drop in the stock won’t morph into a 51% one over the next 43 days. If it doesn’t, the put expires worthless and you get to keep the $100 premium. And if the cost of the naked put is a concern (which it probably is if you’re in a retirement account) you could morph it into a wide bull put spread to control the margin requirement. For example, sell the Feb $115 put for around $1.00 while buying the Feb $85 put for a nickel. You receive almost the same premium but at a pittance of the cost.

And if you want to increase your odds of success further then scale-in. Suppose you wanted to sell three contracts total.

Tier One: Sell 1 Feb $115 put for $1.00

Tier Two: Sell 1 Feb $115 put for $1.50

Tier Three: Sell 1 Feb $115 put for $2.00

By using the scaling method, you’ll use any further loss in the stock over the coming weeks to your advantage by entering the rest of your position at better prices. The only downside is if Apple bottoms immediately you may never have the chance to add the second two tiers. So you’ll only win on a one-third position.

Cry me a river.

If you do follow the scaling method, I suggest you apply it to the exit as well. Maybe something like so:

Tier One: Sell 1 Feb $115 put for $1.00. Target: 20 cents

Tier Two: Sell 1 Feb $115 put for $1.50. Target: 70 cents

Tier Three: Sell 1 Feb $115 put for $2.00. Target: $1.20

In timing the entry, it’s worth waiting for some upside confirmation such as a break of intraday resistance or a prior day’s high. Remember, we’re trying to get somewhat close to the bottom of Apple’s downswing, so if it plunges over the next few days you’ll wish you waited on pulling the trigger.

If you need another example, I recently showed a similar trade setup in the S&P 500.

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