Apple’s Looking Rotten — Here’s a Smart Hedge

by Tyler Craig | December 6, 2012 8:42 am

The bipolar nature of the market was on full display in Wednesday’s trading session. While the Dow Jones Industrial Average spun a bullish tale of optimism and confidence by closing up 0.64%, market leader and tech rock star Apple (NASDAQ:AAPL[1]) painted a decisively more ominous picture, tumbling 6.4% on heavy volume.

AAPL Chart
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With the stock price now south of $540, AAPL has given back the lion’s share of its mid-November rebound from $505 to $595. What began as a strong attempt to return to its former glory has morphed into a classic dead-cat bounce.

Any continued selling in AAPL could have a big effect on the broader market. Given its position atop the market cap hierarchy and the powerful influence it has on the psyche of the trading masses — not to mention the fact that it’s the largest component of both the Nasdaq Composite and the S&P 500 Index — a falling AAPL could very well destroy the bulls’ plans for a year-end rally.

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Not surprisingly, Wednesday’s selling barrage sent scores of traders into the options market in search of protection. The uptick in demand for options caused the CBOE Apple VIX (CBOE:VXAPL[2]) to lift 16.79% to levels not seen since before the tech giant’s earnings announcement in October.

Shareholders who fear AAPL will revisit last month’s lows around $500 might still be in the market for buying protective puts. But the aforementioned surge in VXAPL has made downside puts quite expensive. Instead of buying puts outright, traders should consider structuring a bear put spread to cut costs and exploit the higher volatility levels of out-of-the-money puts.

You could buy the Jan 535 put while selling the Jan 505 put for a net debit of $11.90. The cost is less than half as much as what you’d pay if you simply bought the Jan 535 put. In addition, the Jan 505 put is trading at an implied volatility of 35.7%, which is a couple points higher than the implied volatility of the Jan 535 put.

All told, the risk of the put spread is limited to the initial $11.90 paid at trade entry. If AAPL falls below $505, the spread offers a max profit of $18.10 — which could partially offset losses in the shares if you’re a long holder looking for protection.

At the time of this writing Tyler Craig had no positions in AAPL. 

  1. AAPL:
  2. VXAPL:

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