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Why is AAPL Becoming Dangerous, and What To Do? by Dan Sheridan

by contributor on 02-23-2012 05:25 PM

(Editors note:  Dan sent this to us Monday afternoon, Presidents Day)

The American past time used to be baseball. But the last couple years that has changed. The new American past time has become get long AAPL any way you can and wait for the profits to accumulate. Over the last 2 years, AAPL has gone from around 190 to 500, you figure the yields, staggering! Since June 20, AAPL has risen from 315 to the current level of 502, 60% in 8 months! Let me say that one more time, 60% in 8 months!

 

So why shouldn’t it continue and why is it becoming dangerous? I’m glad you asked. Over the last 2 weeks, AAPL has shown a changed personality that you should be aware of. This personality is much different than the fun loving, get on my back, and I’ll take you up, up, to always higher stock prices. From a psychological perspective, this personality change started about 2 weeks ago around February 3. AAPL was trading at 460, and the March at-the-money implied volatility was around 19. What does that mean in English, Spanish, and Portuguese? It means everything was OK, and no real fear of the downside was popping up. But was it?  The speed to the upside was really picking up. From November 25 to February 3, AAPL went from 363 to 459, 26% in a little over 2 months. Everybody wanted in! On February 10th, AAPL hit 493 and March at-the-money implied volatility in the calls spiked to 27.

 

What’s the big deal? Option volatility usually decreases on the upside as prices go up and fear of the downside isn’t usually there. And remember, this is AAPL, this is America! But last week, the personality disorder got much worse. As AAPL climbed a bit higher to 500, the March at-the-money option volatility climbed higher to 32 in the calls. That is an increase in 2 weeks from 19 implied volatility to 32, an increase of 68% with the stock rising. Why are the option volatilities going up and what does it mean?  First of all why are the option volatilities going up?   SPEED!! Look at a pivotal day, Wednesday Feb 15, AAPL traded intra-day to 526 and closed at 497. That’s a decrease of 5% from the daily high to the close. The stocks rate of speed up and down intraday is really picking up in both directions. Sellers are coming in a bit!  The last time I really saw this kind of speed to the upside was the internet debacle many years ago when stocks were screaming to the upside, do you remember what happened after they went up very fast?

 

What does increasing option volatility mean to the retail trader? It means the green light on the stock may possibly be turning to yellow and you should exercise a bit of caution. Does this volatility news mean I can’t stay bullish on my beloved AAPL?  No, it just means HOW you get long may need to change. This leads me to the strategy for today if I want to be long AAPL but be cautious!

 

Strategy idea: With this disturbingly changed personality in AAPL the last 2 weeks, I would approach any bullish trade very cautiously and make sure the risk/reward looks acceptable to me. In other words, if AAPL nosedives, I’m very comfortable with my total downside risk. I would initiate the below strategy after 1-2 down days.

 

Strategy example:  Stock at 502.50  Buy 1 March 500 call and sell 1 March 505 call for a debit of around $2.40 ( $240). This strategy called a bullish vertical debit spread, allows you to play a high priced stock for a very reasonable cost. We are actually selling an option with more time premium than we are paying for with our long. This is good considering option volatilities (called implied volatility) have skyrocketed the last few weeks. The risk/ reward is about 1 :1 meaning we can make $250 profit potential with maximum risk of $250. If the stock is 505 or higher at expiration ( 2 ½ dollars higher than the current 502 level), I can make 100%. This again is a cheap way with limited downside risk ( $250) to play a very expensive and volatile stock.

 

Be careful and have a great week! 

 

Dan Sheridan      dan@sheridanmentoring.com

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About the Author
  • Mr. Bittman is the author of two books, Options for the Stock Investor, (McGraw-Hill, 1996), and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors, and he has presented several custom courses throughout the U.S., Europe, South America and Southeast Asia. In 1980 Mr. Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993, he was a Commodity Options Member of the Chicago Board of Trade where he traded options on financial futures and agricultural futures. Mr. Bittman received a BA, magna cum laude, from Amherst College in 1972 and an MBA from Harvard University in 1974. In addition to his responsibilities at The Options Institute, Mr. Bittman is also a member of the faculty of The Illinois Institute of Technology, where he teaches in the masters level Financial Markets and Trading Program.
  • Mr. Kearney began his long association with the CBOE when he became an independent Market Maker in early 1981. Mr. Kearney traded options full time on the trading floor until 1992 and periodically thereafter until 1996. In early 1992 he became a founding partner and Registered Options Principal of a brokerage firm based in Chicago, a member firm of the CBOE. Mr. Kearney’s responsibilities included development and implementation of hedging and trading strategies using listed options for their institutional clients as well as their retail investors. Mr. Kearney is the co-author of Understanding LEAPS®, published by McGraw-Hill, September 2002. He has been a regular contributor to many news services including Reuters, Derivatives Week, BARRON’S, CNBC, Bloomberg, Group W, The CBS Radio Network, FORTUNE, Ticker Magazine, Stock Futures and Options, BBC TV and Radio, NPR, and others. Mr. Kearney served on various committees at the CBOE, including the Arbitration Committee from 1984 to 1996. Prior to joining the CBOE Mr. Kearney was a marketing director for NCR Corporation. Mr. Kearney is a graduate of St. Mary’s University (MN), BS, 1971, and pursued his MBA at Lake Forest Graduate School of Management. In 2006 he completed a 3-year SII/SIA program at the Wharton School of the University of Pennsylvania.
  • Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Peter has spoken to thousands of investors across North America the past few years including over 200 webinars for the CBOE and member firms on trading options. He can also be seen each week on CBOE-TV with his show, Strategy of the Week. In addition to his responsibilities at the Options Institute, Peter serves as an Instructor for the Options Industry Council – an organization representing the options industry in the U.S. Prior to working at the Options Institute, Peter was a highly successful market maker for many years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management at the Options Institute.
  • Russell Rhoads, CFA, is an instructor with the Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management, Caldwell & Orkin Investment Counsel, TradeLink Securities and Millenium Management. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies. Since joining the Options Institute he authored Option Spread Trading: A Comprehensive Guide to Strategies and Tactics which was released in January 2011 and recently finished work on Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes which was published in August 2011. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois – Chicago and acts as an instructor for the Options Industry Council. He is a double graduate of the University of Memphis with a BBA ('92) and an MS ('94) in Finance and also received a Master's Certificate in Financial Engineering from the Illinois Institute of Technology in 2003.
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