How to Profit from Apple's Missed Earnings

This week’s rare earnings miss by Apple ( AAPL - Analyst Report ) might have shocked most investors (and lost them a little money), but it was A-OK if you had an Iron Condor options position.

And the subsequent -$25.95 drop the next day (or -4.32%) to $574.97 put this trade on even surer footing.

At the moment, there’s a case to be made for Apple going even lower. A big miss on both earnings and sales is rarely a good sign. But, in life, some things deserve an asterisk. And Apple’s earnings are likely to soar once again when they release their next-gen iPhone (the highly anticipated, yet unofficial, iPhone 5).

In fact, given the weight of the miss, but also the anticipation for the lucrative new iPhone release, it’s hard to make a case for either side (bull or bear) to gain the upper hand.

But a sideways trending Apple will be just what the doctor ordered for this strategy.

Definition

The iron condor is classified as a neutral strategy.

For instance, a bullish strategy, of course, means you’re expecting the market to go up. A bearish strategy has you expecting the market to go down. But with this strategy, instead of picking a direction, you’re defining a range. In other words, the price can go up by a certain amount, or down by a certain amount, or trade sideways. And any one of those three scenarios would result in the same exact maximum profitability.

This is considered a low risk, but high probability trade.

The Iron Condor is usually put on as at a credit, meaning you’ll be a net collector of premium. And there are four parts to this trade.

Set Up

The best way to explain it is go over an actual trade I just put on a short while ago.

On June 20, 2012, when apple was trading at around $585.00, I:

• Bought to open 1 August 2012 630 call at 10.90 (or $1,090 debit)
  
• Sold to open 1 August 2012 625 call at 12.34 (or $1,234 credit)

• Sold to open 1 August 2012 545 put at 12.91 (or $1,291 credit)
  
• Bought to open 1 August 2012 540 put at 11.65 (or $1,165 debit)

Essentially, an Iron Condor is comprised of two credit spreads (one on the call side and one on the put side). We received a net credit of $144 on the call side, and we received a net credit of $126 on the put side, for a combined net credit of $270.

So the maximum profit on this kind of trade will always be your credit, and in this example, it’s $270. And we'll see that as long as Apple, at expiration (Aug. 17th), closes between $545 on the low end and $625 on the high end. That’s an $80 range.

The maximum loss would be $230. That would be seen if Apple closes below $540 or above $630.

Show Me

Let’s say, at expiration, AAPL closes at $545. That means:

• The 630 call that I paid $1,090 for would expire at $0 for a loss of -$1,090.
  
• The 625 call that I collected $1,234 for would also expire at $0, meaning I kept the entire $1,234.
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• So that’s a net gain of $144.

On the put side:

• The 545 put that I collected $1,291 for would expire at $0, meaning I kept the entire $1,291.
  
• The 540 put that I paid $1,165 for would also expire at $0, for a loss of -$1,165.
  -----------------------------------------------------------------------------
  
• So that’s a net gain of $126.
  
• Add both sides up, and that’s a $270 gain.

If it closed at the high end of the range, or in the middle of the range -- as long as it was within that range of $545 and $625, the outcome would be the same.

But once you closed beyond the farther out strikes that you bought, then you've generated your maximum loss, which is the difference between the largest spread you have on and your maximum credit.

For this trade, the largest spread we have, on either side, is a $5 spread. (540 to 545 and 625 to 630). One $5 spread is equivalent to a $500 risk.

For example, let's say at expiration, AAPL closed at $525, that means:

• The 630 call that I paid $1,090 for would expire at $0 for a loss of -$1,090.
  
• The 625 call that I collected $1,234 for would also expire at $0, meaning I kept the entire $1,234.
  -----------------------------------------------------------------------------
  
• So that's a net gain of $144.

On the put side:

• The 545 put that I collected $1,291 for, is now in-the-money, and would be worth $2,000, meaning I lost -$709.
  
• The 540 put that I paid $1,165 on, is also in-the-money, and is now worth $1,500, meaning I made $335.
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• So that's a net loss on this side of -$374.
  
• Total loss = -$230 ($144 gain, less -$374 loss = -$230 net loss).

Apple could go down to zero or up to infinity, and the loss would still be the same.

So with this trade, you can place non-directional bets on a stock, and make money as long as it stays within your determined range.

To increase your probability of success, you want to establish a wide enough range. And since your profit is limited to the credit you collect, you want to put this on for as large of a credit as possible.

Below is a chart depicting the range I want Apple to stay within by Aug. 17th, which is the last trading day for the August 2012 options. (See the two horizontal lines delineating the range) This is what the chart looked like at the close of business on July 25th.

Take note, in this trade example, the potential gain is $270 while the potential loss is $230. That's close to 1 for 1 reward to risk ratio.

Typically, when placing a directional trade, I'd like my potential reward to be 3 to 1 or better. But there's only one way to win on those kinds of trades.

In this instance, since there's 3 ways to profit (up, down, or sideways), the lower reward to risk ratio is made up for the higher probability of winning.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.