Options Mailbag – Your Questions Answered

From time to time I use this column to answer questions sent in by readers. Today we’ll tackle a few recent ones.

One reader wrote with a question regarding the upcoming 7-for-1 split in Apple stock. By the time you read this the split will have already happened, so this discussion is purely educational, which reminds us that short articles like these can only give you tiny glimpses into the world of options. If you’re serious about trading them, you need to get a real education first.

Also, I could not respond to that specific question individually, as that would constitute “investment advice” within the definition in US regulations. We are educators, and are not permitted to give “investment advice.” Our mission is to give you the tools to make your trading investment decisions for yourself – and not rely on those who are licensed to give “investment advice,” who often have another agenda.

With that reminder, let’s look at the question:

May 13. 2014:

I wanted to get your opinion on a play I was considering on the forthcoming Apple stock split.

Split Date : June 2, 2014

Current Market Price: $590

I am considering the following 2 plays individually BEFORE the split.

1. Buy ATM 570 or 580 Calls expiring in Jan 2015. They are trading roughly at $45 – 52.

The thought behind this play is to get in before the split. When the split occurs, each contract will be for 700 shares at the new price. Once the split is completed, the stock should become far more affordable and attractive, hence causing a spike due to demand.

Let’s look at this question. The reader’s idea was to buy call options on Apple before the split. He believed that the lower post-split price would make the stock accessible to a whole new group of buyers, and that that should increase demand and hence the stock price.

Here is Apple’s chart as of May 13:

After the split, each stockholder would own seven times as many shares, at 1/7 of the value of the old shares. Each option contract would have its strike price and quantity adjusted, so that it would then cover 700 shares instead of 100, and at a strike price 1/7 of that on the day before the split.

The reader proposed buying call options that were a bit in the money (the 570 or 580 calls). He suggested a distant expiration (January 2015).

Looking at the above chart of Apple, we can see that the stock was just at a supply zone created in December, 2012 that had topped out at $594.59. Doing a bullish trade here was a bet that the stock would break through that level. Was that a reasonable expectation?

It could be. For the last year, Apple has been in a strong uptrend, respecting its demand levels and breaking through its supply levels. Add to that the recent strong earnings and the upcoming split, and a bullish trade here could make sense. It was possible that the December level might hold and lead to a pullback to the demand level around 525. But the reader was thinking of buying options that expire seven months in the future. As long as any pullback here was temporary, the position had time to work out. And if Apple did drop through its support at $525, the loss on each 570 call contract would be about $1800-2600 depending on how that drop affected implied volatility (calculated from the option pricing diagram, as taught in our classes), out of its $5200 cost. The potential payoff was unlimited.

An argument in favor of the trade was the very low level of implied volatility. On May 13, the reading was 17%, the lowest level in years, if not ever. So options were extremely cheap. This reduced the risk of buying them.

This idea was very promising. If in fact the split did increase the demand for Apple shares (and after all, that was the purpose of the split), there was substantial upside, with limited risk.

So far, this idea would have worked out very well. On May 30, three days before the split, Apple stock had already cleared the supply at $594 and was trading around $637. The 570 Jan 2015 calls were at about $83, for a 60% increase since May 13.

Here is the chart as it looked intraday on May 30:

If the reader took this trade, he would have had a decision to make. There was already a very nice profit in this trade, and there has been quite a rally on the run up to the split. It was quite possible that this rally has exhausted the buyers, and that the price could collapse after the split. Should he sell the calls and take the easy profit, or hang on for profits that could be much bigger?

This is a high-class problem to have. If he had bought multiple contracts, he could do a combination. The reader could recover all of his cost and then some by selling 2/3 of the contracts he bought, the remaining contracts would be free.

This trade showed solid thinking. This is the kind of analysis we like to see. I congratulate the reader on his keen eye.

For comments or questions on this article, contact me at rallen@tradingacademy.com