October 6th, 2012
For some traders Apple is underpriced yet too expensive to buy
By Chris Ebert, Zentrader.ca
Apple (AAPL) has certainly been a great stock to own in 2012. Having begun the year trading near $400 a share, the price has risen some 65%, briefly topping $700 in September. At current prices, there are traders who simply cannot afford to buy the stock even if they want to do so.
Click on chart for larger image.
Even a trader with a sizable account of $100,000 might be reluctant to buy just 100 shares of Apple. At the current price per share near $670 such a purchase would require putting $67,000 of the account at risk. Taking such a risk on any one stock is certainly not advisable for most traders. Not only does it have the potential to cause huge losses, but it also greatly limits the amount of capital available for other trades.
Options are not just for professionals
Many individual stock traders may not realize that their broker will allow them to trade options. Sometimes it’s as simple as asking. Some brokers offer instant option trading approval upon the completion of a quick online form. While the requirements vary from broker to broker, a trader with as little as $2,000 may qualify, although there may be restrictions on the type of option trades that are permitted.
There are ways to use options that are both complicated and very risky, but there are also simple option trades that are no more risky than trading stocks. Using options as a replacement for buying stocks is not only a straightforward process, but it can sometimes be less risky than buying the stock itself.
Options have many different uses; speculation, generating income, or protecting gains to name just a few. Not all traders are using them as a replacement for buying stocks. The best option for those other purposes is not necessarily the best one to use as a replacement for buying stock. For a trader looking to buy a call option as a replacement for 100 shares of Apple stock, the “best” option is the one that will perform as closely as possible to a trade in which 100 shares of Apple stock was purchased outright.
A needle in a haystack
There are literally hundreds of call options to choose from on Apple, as is the case with many stocks. But there are only a few of them that are appropriate for use as a replacement for stock ownership. Finding the ones that are appropriate, not only for the intended purpose, but also for the preferences of the individual trader is a fairly straightforward process.
It’s good to be in-the-money
Call options that change in value most closely to the change in the price of a stock are those that are in-the-money. That is, they have a strike price that is lower than the current price of the stock. For example, when Apple shares are trading at $670, call options at the $650 strike price are in-the-money. Right off the bat, half of the haystack is eliminated. Only in-the-money call options will be useful.
The lower the strike price of the call option, the more closely its performance resembles that of the stock. A call option at the $600 strike price will track the profit and loss of the stock more closely than a call option at the $650 strike price.
Owning a call option at the lowest possible strike price will most resemble ownership of the stock itself. However, that call option will also be the most expensive. There is also a very good chance that such a call option would be difficult or impossible to purchase at a fair price. Just like stocks, some options are popular among traders, and others are not. Generally, the further away the strike price of the option is from the current price of the stock, the fewer traders there will be.
Choosing the rate of time decay
Because the “best” call option to replace stock ownership is both expensive and difficult to trade, it becomes necessary to make a concession. The strike price of the option will need to be raised somewhat. Just how far to raise the strike price depends on the specific stock and also the preferences of the trader. Raise it too little and the option might still be too expensive or too difficult to trade. Raise it too much and the option will become subjected to excessive time decay.
All options are subjected to some degree of time decay. That is, they tend to lose a portion of their value each day. On some options the rate can be very slow, on others it can occur quite fast. In choosing the best call option on Apple, a trader must decide on an acceptable rate of time decay. Is it worth losing $500 per week to time decay in order to control $67,000 worth of Apple stock? The decision is up to each individual trader. After all, it would take a $5 per share gain in the share price of Apple over the course of one week to offset the $500 lost to time decay on one call option.
There is no right answer. $500 may be acceptable for one trader while it is possible that another trader might decide that $200 per week was the maximum amount of acceptable time decay.
Converting time decay to time value
If $200 per week is an acceptable rate of time decay, an option purchased one week before its expiration date can have a maximum of $200 in time value at the time of the purchase, or $2 per share. If it is purchased six weeks before the expiration date, it can have a maximum of $1,200 of time value, or $12 per share, because the average amount of time decay over those six weeks cannot exceed $200 per week. The same process applies to every expiration date. At six months from expiration the maximum amount of time value would be $52 per share while at one year it would be $104, and so on.
Finding the needle
For any expiration date, there is a very simple way to find the call option with the appropriate amount of time value: Find the put option that is trading at a price (or premium) equal to the time value being sought. The call option at that strike price will have a time value approximately equal to the premium of the put option.
For example, if a put option at the $640 strike price has a premium of $2 per share, the call option at the $640 strike price will have a time value of $2 per share. This is not exactly true on some options, especially if the underlying stock pays a dividend, but it is not necessary to be exact. For the purposes of finding the needle in the haystack, approximation is sufficient.
Making a list
Starting with the nearest expiration date, and proceeding to later expiration dates, find the strike price of the call option that has the correct amount of time value that was calculated for that date.
For example, with Apple shares trading at $670, the list might look like this:
- October 12, 1 week away, $2 time decay per week , $2 time value, $640 strike price, $32 premium
- October 20, 2 weeks away, $2 (avg.) time decay per week, $4 time value, $630 strike price, $41 premium
- November 17, 6 weeks away, $2 (avg.) time decay per week, $12 time value, $615 strike price, $63 premium
How to buy Apple stock for $30 a share
Any of the options on the list will fit the original criteria that the trader decided was appropriate. The call option will perform in a way that causes it to have a profit or loss that is approximately the same as owning 100 shares of Apple stock, and the average weekly loss due to time decay will be $200. That is not to say every option on the list will produce identical returns. Slightly different rates of time decay may cause slightly different returns. In general though, under normal market conditions the returns will be relatively similar.
Now the haystack has been totally eliminated, and what is left is a handful of needles from which to choose. So which of them is the best? Again it depends on the trader.
If the November 17th options are chosen, the $63 per share premium is about twice as much as the $32 premium on the October 12th weekly options. There is a much higher risk of loss if something suddenly goes horribly wrong with Apple.
If the weekly options are chosen, the position could require twelve trades over the course of six weeks. The call option would need to be sold the day before expiration and then the next week’s call option would need to be purchased. It would also be necessary to adjust the strike price of the following week’s option so that it conformed to the $2 time value that was previously deemed appropriate. That could potentially require a different strike price each week.
Options are not magic
While it is possible to use options to open a trade that is essentially equivalent to buying Apple stock, for $32 per share, it does not mean it is advisable. A trader with a $100,000 account would be taking on the risk of Apple shares plummeting, and the call option expiring worthless. That’s a $3,200 loss in one week, or more than 3% of the total account, and while that is a higher percentage than many experienced traders will tolerate, it is not unheard-of. A trader with a $10,000 account would be risking nearly a third of the account on a single trade, on a single stock; that is well beyond the tolerance of most experienced traders.
In-the-money call options should be purchased on Apple only by traders who were going to purchase Apple shares anyway. And the option trade should be handled the same as the stock trade.
For example, if a trader would normally use a $10 trailing stop on Apple stock, then the call option should be sold when Apple shares reach the level of that trailing stop. If Apple shares were to climb from $670 to $700 with a $10 trailing stop, they would be sold if the price then declined to $690. If the price does decline to $690, that is the time to sell whatever call option is owned, no matter what strike price and expiration was chosen for the option, and no matter what profit or loss exists on that option.
About the Author
Christopher Ebert uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”