Apple: A Lesson in Trading Volatility

To say that the markets have been volatile recently would be an understatement. So let's take a fresh look at this roller coaster environment to better understand what's happening and how we might be able to profit from it.

Understanding the VIX

The most widely quoted volatility index is the CBOE (S&P 500) Volatility Index (VIX). While the VIX represents investor demand for options -- both puts and calls -- you can also view the VIX along the spectrum of market mindset:

  • Complacency: Low VIX / Fear: High VIX
  • Greed: Low VIX / Fear: High VIX
  • Conventional wisdom says that the VIX should trade in a range of 20 to 30, with 30 being the level of "oversold" markets and 20 or below being "overbought" markets. Let me dispel that as a statistical myth.

    The average level for the VIX is about (and I am rounding here) 19.15, with a standard deviation of 6.35. Thus, the normal range, if you look for one-standard-deviation moves, is between 12.80 and 25.50. As of the close on Monday, Oct. 6, the VIX stood at 52.05 and currently, it's in the 70s. This is an extremely elevated level that is several standard deviations above the mean.

    (Don't miss " Options Know-How: Morgan Stanley, Google")

    Profit from Volatilty With Options: Apple

    I could not think of any better stock that represents investor sentiment and hedge fund activity than Apple ( AAPL).

    While Apple stock has fallen significantly since Sept. 19, volatility for the stock has skyrocketed. This is depicted in the following Bloomberg screen:

    Click here for larger image.
    Source: Bloomberg
    Here are a few observations from this chart:

    1. The short term volatility, defined by the 10-day (or two-week) historical volatility has climbed 69% since Sept.19 to a level of 126.68%. Compare this to the volatility for a consumer staple company like General Mills ( GIS), which was slightly elevated over the same period of time, but stood at a mere 25.05%.

    Clearly, investor worries and forced selling by hedge funds have contributed to Apple's skyrocketing volatility.

    2. As Apple's historic volatility has gone up, so has Apple's implied volatility for call and put options. Each has risen from around 50% to about 111% during the period in the above chart. (Implied volatility is a variable in the Black Scholes model for options pricing. If all other variables, such as stock price, interest rates, dividends and time remain constant, then an increase in volatility will equate to an increase in both option and put prices.) This chart is telling us that there is more fear and risk being built into the pricing of Apple by options buyers.

    So can we take advantage of the increased volatility in Apple?

    Yes. Here are two ways to do it: calls and puts.

    First, understand this: Like stock trading, when trading options, we essentially want to "buy low and sell high." Thus, with Apple's volatility levels soaring, we should look at selling opportunities rather than buying opportunities.

    Let's start with Apple's call options:

    Click here for larger image.
    Source: Bloomberg

    At these elevated levels of volatility, I would be a seller of Apple call options. According to the above Bloomberg screen, with 10 calendar days and just 8 trading days remaining to options expiration, it appears that prices and implied volatility for Apple calls are better sales than purchases.

    If I owned Apple, I would be inclined to sell covered calls at strike prices ranging from 90 to 120. This would allow me to take in some option premium, which would create a hedge on my Apple position.

    As the option seller, the worst case scenario is that Apple rises above the strike price at expiration and you lose your stock. Of course, you can always buy it back.

    Here's a walkthrough of one scenario: Let's say I sold the Oct 110 calls for $2.45. If Apple remains below $110 at expiration, then I get to keep the $2.45. If Apple rises above $110 at expiration, then I will have to sell my Apple for $110 no matter where the stock may be trading at that time.

    Now, here's a look at Apple's put options:

    Click here for larger image.
    Source: Bloomberg

    Based on the above screen, I would be looking to sell put options "naked" at strike prices that have implied volatility at or above the 111% implied stock price volatility. This would be put options with a strike of 90 or lower.

    Naked selling of put options is taking a position that the stock price will close above the strike price. It is a mildly bullish strategy and puts the seller at risk of having to buy the stock should the expiration price of the stock fall below the strike price. The good news is that you get to keep the option premium no mater where the stock may close relative to the strike price at expiration.

    For example, let's say I sold the Oct. 90 puts. I would receive $3.65 per share. If the stock closed at or above $90 at expiration, then I would keep the $3.65. If the stock closes below $90 on expiration, then I would have to buy stock at $90, but still keep the $3.65 reducing my effective cost of Apple to $86.35.

    Finally please be aware that option trading is highly risk, must be performed in a margin account and is subject to broker approvals.

    Your Homework

    Try to take advantage of these extraordinary market times, by looking at opportunities being created by historical spikes in volatility:

    1. See if you can design a trading strategy with the VIX or VXO as your basis for a trade.

    2. Look for stocks with skyrocketing volatility and try to sell options to match your fundamental investment thesis of the underlying stock.

    At the time of publication, Rothbort was long AAPL, although positions can change at any time.

    Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

    Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

    Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

    For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at Scott appreciates your feedback; click here to send him an email.

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