The Rise and Fall of the AAPL's IV: Part II

Posted February 25th, 2011 by Josip Causic in Education

The Rise and Fall of the AAPL's IV: Part II

This article is titled Part Two due to the fact that a very similar trade was placed on AAPL around the previous Quarterly Earnings Release time. The link to that article is here, The Rise and Fall of Apple's I.V.. The main difference between what was described in that article and this one is not the rise and fall of AAPL's implied volatility, but the options strategy that was used. In the article mentioned above, a Bull Put was used; in the current one, a bear call was used. Yet, if you scrutinize the intricacies of these short vertical spreads, it is observed that, in essence, both are in principle the same; the seller gets paid up front.

Let us start from the beginning and build the whole thing in pieces. Similarly to the last AAPL trade, I was teaching an options class (this time in NYC) and when a ticker was requested, the overwhelming majority of the students wished to discuss AAPL. The steps to which I subject my options trades are as follows: Fundamental analysis (F.A.) first, technical analysis (T.A.) next, and last but not the least important, the I.V.

One might wonder what is there to look up fundamentally on a stock like AAPL? It is a solid company. Period. Generally, when trading options on equities, I do look for three fundamental things: Dividends, stock splitting dates and earnings release (E.R.) dates. In the case of AAPL, the first two did not apply, while the E.R. was around the corner.
After checking the chart on which I had inserted a Bollinger Band as my technical indicator, I proceeded to check the current readings of AAPL's I.V. in relationship to its previous 52-week high and low of its Historical Volatility.

Figure 1

Figure 1 above shows visually that the current AAPL's I.V. was closer to the 52-week high than to the 52-week low; or mathematically speaking, 44.50 ñ 32.50 = ten percentage points away from the High, versus the reading of 22.23% on the other side (32.50 ñ 10.27)

Next, let us sum up what this means for our options strategy: Be a seller of options because the premium is overpriced. Do we have a clear reason why AAPL was overpriced on Tuesday, 1-18-2011 while it was trading at the $341.60 level? Yes, the reason was all over the news, Steve Jobs blah, blah, and blah. Also, the E.R. was about to come out. Coincidentally, it was also January option expiry week. Hence, there were many reasons for overpriced AAPL options out there.

Having checked those three things (F.A., T.A. & I.V.), I went back to the charts with my students to examine multiple time frames. There was no mistake that just a day before Steve Jobs made his announcement, AAPL was trading at its 52-week high. The next day it gapped lower and by the time the class was done with the technical analysis on various time frames, AAPL was trading at $341.60 and a Bearish strategy in which we would have two legs was selected.

The long leg, which we bought instead of owning the stock, was the Jan 355 call. At the time of our entry, the call was trading at 2.78, so $278 dollars went out of our account. This Jan 355 call was basically three steps OTM with a delta of 0.17, meaning the 355 call had only a 17% chance of expiring in the money (ITM). In other words, for us to break even on the 355 call, the price action would have to lift from $341.60 to $357.78 which is $16.18. By the way, the breakeven point (BEP) of the 355 call is calculated simply by adding the premium paid to the strike price.

The premium that we took in for the short leg which we sold against our long 355 call, was so much greater than the debit that we paid out for that long call. We sold to open (STO) the Jan 350 call at $4.15, with the expectation that AAPL would close below 350, as it was trading at $341.60 giving us room of almost 9 points to be wrong.

To make things even simpler, I have created a chart, Figure 2, which repeats the same data in a more aesthetic way. Delta's are in brackets [ ].

Figure 2

Briefly, going over the table above, the top line lists the time and price of the underlying. The rest of the data deals with the option specifics. Notice that I have used squared parentheses for the Delta readings. On line five, I have given the aggregate of both the sold call, which has a negatively correlated delta of 0.22, and the long call with the positively correlated delta of 0.17. The difference of these two gave us a delta of negative .05, which means that our position is actually a Bearish one.

If the spread is bearish with a negative delta, then what needs to happen follows. AAPL would have to close below 350 at the expiry in order for us to keep the maximum profit, which by the way, would give us the (ROR) rate of return of 37%. If by any chance that did not happen, follow-up actions would be required.

In conclusion, as one might assume, the earnings came out, and right after that, the I.V. dropped and on Friday AAPL had closed at around $326 and some change. We were able to buy back our sold call for less than a nickel. This article has addressed the issue that the I.V. always goes up prior to the E.R. and then immediately after falls. Knowing that by itself is not a Holy Grail, but technical analysis combined with the correct options strategy is what gives us an edge. Have the green trading.

- Josip Causic
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