Repairing AAPL Damage with Options

by Joseph Hargett | May 24, 2012 11:06 am

Note: A previous version of this story was published in error. We apologize for any inconvenience.

Apple Inc. (NASDAQ:AAPL[1]) shares have traveled a rough road since the company released its second-quarter earnings report on April 24.

The initial prognosis looked good, as AAPL gapped above the psychologically significant $600 level following the report. However, due to a combination of lower-than-expected third-quarter guidance and broad market weakness, AAPL has since filled in its post-earnings gap higher and then some.

Unfortunately, many AAPL investors may have viewed the gap above $600 as a buy signal, resulting in painful portfolio losses over the past several weeks. While exiting these positions to limit losses or recoup a portion of the initial investment is likely the furthest thing from most investors’ minds, there are still ways to mitigate the damage.

For one, AAPL appears to be in the midst of a rebound that should push the stock back to post-earnings levels. However, if you’re not afraid to add a little risk to your portfolio, you could recoup those losses much more quickly through options trading.

One such options strategy is known as a “stock repair strategy.” This particular play is often utilized by stock traders who remain firm in their bullish assessment of their initial investment. In other words, if you’ve lost faith in a stock’s ability to rebound, this strategy isn’t for you. Since AAPL remains in a long-term uptrend and should have plenty of upside ahead, AAPL traders can take full advantage of the leverage offered by options to more quickly recoup some of their losses.

For the sake of this example, let’s say you purchased 100 AAPL shares for $610 shortly following the company’s quarterly earnings report. While your stock position has shed roughly 6.6% since initiation, you remain firm in your belief that the stock will eventually come around. That said, you’re also concerned about the current mood on Wall Street, the situation in Europe, and the potential for technical resistance near $620.

To initiate this stock repair strategy, you’ll retain your 100 AAPL shares (obviously), while simultaneously purchasing one August 570 call (which were last asked at $38.85) and selling two August 610 calls (which were last bid at $21.70).

When the dust settles, you end up with a net credit of $4.55, or $455 per set of contracts (aside from commissions and margin requirements). Furthermore, both of your sold August 610 calls are essentially covered: one by the 100 AAPL shares in your portfolio, the other by the purchased August 570 call. As you can see, while you get paid (via the net credit) to enter this stock repair strategy, you run the risk of having your 100 AAPL shares called away if the stock bounces back too sharply.

There are three potential outcomes for this stock repair strategy.

First, AAPL shares fail to recover, extending their losses through the August option expiration. In this scenario, the options used to construct the stock repair strategy will expire worthless, but you will retain the initial net credit of $4.55. Depending on how far AAPL falls, this credit could be of little comfort, but at least you didn’t pay to enter the position.

Second, AAPL shares rebound but fail to recover completely. In this case, you would retain the net credit of $4.55 and bank an additional profit by selling-to-close the August 570 call. For instance, if AAPL closes at $600 on August expiration, you could sell the August 570 call for $30, increasing your total profit on the options portion of the position to $34.55 and lowering your loss on the overall position.

The final scenario involves AAPL rallying back to $610 or even higher by the time August options expire. The sweet spot occurs if the stock closes at $610, thus netting you $40 through selling-to-close the August 570 call while allowing you to keep the initial net credit of $4.55.

However, if AAPL rallies past $610, the August 610 calls will likely be exercised, forcing you to sell 200 AAPL shares for $610. While these shares will be covered by your portfolio and exercising the 570 call, AAPL will no longer be a part of your portfolio.

  1. AAPL:

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