Apple stock continues to slide. Lately, it has become nerve-wrecking to hold shares of the Cupertino company, as they dig deeper into correction territory and seem to struggle to find a bottom.
This may be a good time to talk about how to maintain upside exposure to Apple stock while protecting the downside from sharp losses. This can be achieved in several different ways through Apple options.
A quick primer on Apple options
Options are tradable financial instruments that give their buyer the right to buy (call options) or to sell (put options) an underlying asset. Options can be written on a number of securities, including the S&P 500 index, a bond fund, or even Apple stock.
Of course, to earn the right (but not the obligation) to buy or sell something whose value can fluctuate, the option buyer must pay a price called a premium. Option premiums are very much like car insurance payments: the buyer of the policy pays for the right to demand compensation from the policy issuer (the insurance company) in case of a property loss (say, damage to the car caused by collision).
Protecting the downside through call options
One approach to being exposed to an eventual rise in Apple share price without risking losing too much is through a call option. For example: rather than owning Apple stock and holding it for a year, an investor could buy an in-the-money, $110 strike June 2022 call contract for $22 per share for implied volatility of 30%.
Bear with me as I dive into the details and break down what the terms above mean, one at a time, in the order that they appeared:
- In-the-money: it means that the option is already in a profit position (excluding the premium paid). That is, the buyer could exercise his or her right to buy Apple stock at a price that is lower than the market price.
- $110 strike: this is the exercise price that the option holder would have to pay to own Apple stock, regardless of the share’s market price.
- June 2022: this is the expiration date on the derivative. The option holder could buy Apple stock at $110 apiece anytime in the next 12-plus months.
- Call contract: worth mentioning, each call contract gives the buyer the right to buy 100 shares of Apple, not only one.
- $22 per share: this is the premium, or the cost of the option contract on a per-Apple share basis. One contract would cost $22 times 100 shares of Apple, or $2,200, for about $12,300 notional exposure ($123 Apple share price times 100 shares).
- 30% vol.: this is what the market price of the Apple option implies about volatility expectations. The higher this number, the more expensive the option contract is. For reference, Apple shares have had historical annualized volatility of 27% over the past decade.
This very simple buy-and-hold trade would effectively cap an investor’s downside risk in Apple to about 10%: $110 strike price relative to the current share price of about $123. But should Apple stock shoot to the moon over the next year, the investor would capture the entire upside swing, without restrictions.
The cost of this asymmetric opportunity would be what is known as the “decayable value” of the option: that is, the $22 premium minus the $13 intrinsic value (i.e. $123 market value minus $110 strike price). In other words, the investor would be giving up about 7% worth of an outright Apple stock ownership ($9 divided by $123) to set up this position.
Below is a profit and loss graph that helps to paint a picture. The x-axis represents the possible prices for Apple stock, ranging from $50 to $200. The y-axis is the option trade’s profit or loss, per share of Apple, at each hypothetical price point.
Notice the limited downside, unlimited upside setup and breakeven price (i.e. no gain, no loss) at just north of $130 per share.
Protecting the downside through put options
Investors who already own Apple stock do not need to sell their positions to cap their downside exposure. A similar effect to the strategy described above can be achieved through put options – the right to sell Apple stock at a predetermined price.
A $110 strike June 2022 put contract currently sells for about $9 per Apple share. Should Apple tank and dip below $110 over the next 12-plus months, even if the decline is substantial, the investor could sell his or her position for a fixed price of $110 apiece.
Not a surprise, since the markets are largely efficient (a.k.a. call and put parity), the put premium also represents (1) implied volatility of about 30% and (2) a “cost” of roughly 7% worth of Apple stock to set up the position ($9 divided by $123, as the entire option premium is decayable in the case of an out-of-the-money contract like this one).
The Apple Maven’s take
Over long periods of time, Apple stock tends to rise in value. I believe that this will continue to be the case. Therefore, investors who buy and hold shares and do not check their brokerage accounts on a regular basis might as well ignore market noise and bypass loss mitigation option strategies.
Other investors, however, might have a different risk profile. If watching Apple stock dip 15%, 20% or more from the peak gives them severe heart palpitations, protecting the downside – even if at a material cost – might make sense in the current market environment.
There are a couple other considerations. First, not all investors have the permissions to trade options, so check with your brokerage firm. Second, option gains can have a different income tax treatment than stock gains, consult your tax professional.
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(Disclaimers: this is not investment advice. The author may be long one or more stocks mentioned in this report. Also, the article may contain affiliate links. These partnerships do not influence editorial content. Thanks for supporting The Apple Maven)