Thursday after the close, Apple (AAPL - Free Report) will be the last big-cap tech stock to report earnings this season. We’ve seen fairly good results so far, but in some cases, various items have given investors cause for concern. Amazon (AMZN - Free Report) and Alphabet both beat estimates on the bottom line but saw their shares punished because of concerns about slowing revenue growth. Microsoft (MSFT - Free Report) saw a 6% rally the day after it reported top and bottom line beats and Facebook (FB - Free Report) traded in both positive and negative territory after a strong report, eventually finishing up almost 4% on the day after earnings.
Throughout the month of October, volatility was the rule and unfortunately for the big tech stocks, the results were mostly negative. The S&P 500 gave up nearly 10% - essentially all of its gains for the year – and most of the big tech stocks fared about the same. Amazon did much worse – losing 20% of its value on the month – and giving up its spot in the Trillion Dollar market-cap club.
The steadiest and best performer during the October volatility was Apple, which lost less than 4% and experienced significantly less price volatility than even the broad market indexes.
Though shares of Apple have been less volatile than the indexes, implied option volatilities on Apple are higher. Because of Apple’s enormous market cap, it is the largest holding in index funds and ETFs, at 6% of the S&P 500 and 13% of the Nasdaq 100. Thanks to high implied volatilities in the indexes and the associated volatility arbitrage opportunities, Apple vols rise when market vols rise. The upcoming earnings announcement exacerbates the effect.
Over the past four years, Apple has made a habit of just slightly beating the consensus earnings estimates. Take a look at the Price, Consensus and Surprise chart below. You’ll notice 18 small green arrows signifying small positive earnings surprises and one small red arrow – a small earnings miss.
The average move in AAPL shares the day after earnings reports during the last nine quarters is just 4.15%. The November 200 strike straddle is currently priced at approximately $16, implying a 7% move between now and expiration which is 16 days away.
This appears to represent a selling opportunity, but simply selling a straddle is fairly dangerous because if Apple were to experience a significant move between now and expiration, the risk is theoretically unlimited.
We can control that risk and still capitalize on relatively high implied volatilities by selling an “iron butterfly” in which we sell the at-the-money straddle and simultaneously purchase an out-of-the-money strangle.
The current market prices of the options are:
210 put $4.50 $4.70
220 put $8.10 $8.40
220 call $7.10 $7.30
230 call $2.95 $3.10
If we sell the straddle and buy the strangle near the middle of the bid-ask spreads, we can collect $7.70. Because the most this spread can be worth is $10, our maximum loss is only $2.30 per spread.
If Apple shares are lower than $210 or higher than $230 at expiration, we will suffer the maximum loss, but at only $230/spread, the max loss is quite manageable. If Apple stays close to $220, we will collect most or even all of the premium we collected.
Of course, the chance of predicting the exact price of any stock on a particular day - especially options expiration – is quite small, and so therefore are the chances of making the maximum profit on this trade. The goal is to collect as much of the relatively high premiums as possible.
One more thing to keep in mind is that since we’ll be short the higher premium options, we will have to either buy back one or both of the short options or trade the stock to close the trade. If we simply keep the spread on until expiration, and the stock is between $210 and $230/share, we’ll end up either long or short 100 shares of Apple as a result.
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