On April 4th I published an article titled "Kaeppel's Corner: Apple is Toast (Well Maybe, Sort of)"
http://www.optionetics.com/marketdata/article.aspx?action=detail&aid=24324. The gist of that article was that AAPL was running out of upside momentum and was due for a pullback. The primary catalyst for this belief was that the price of the stock kept hitting new highs but in each case the 3-day RSI indicator hit a lower high.
As you can see in Figure 1, the stock went a little bit higher over the next couple of days and then broke hard to the downside.
Figure 1 – AAPL runs out of momentum then sells off
Now if I were a smart self promoter I would have titled this week’s piece “Kaeppel’s Corner: Shaazam! Jay Calls the Top in Apple!!!!!” But the reality is that I was not trying to call “the top”, but rather, well, I simply noticed that the stock seemed to be running out of momentum and wondered if there was some limited risk way to play a potential move to the downside. In fact, probably a more accurate title for this week might be, “Kaepppel’s Corner: If You Make Enough Predictions – The Law of Averages Being What they Are – Sooner or Later You’re Bound to Get One Right.” But I was afraid of crashing the Optionetics website.
At the Time
At the time of the original article I included a position referred to as an “out-of-the-money butterfly spread”, or OTM butterfly for short. In the original article I displayed it as a simple 1 x 2 x 1 position. For our purposes here it is referred to below as 4 x 8 x 4 (same ratio, just a bigger position.
-Bought 4 May 610 puts @ 23.95
-Sold 8 May 560 puts @ 8.60
-Bought 4 My 510 puts @ 2.86
The total cost to enter this 4 x 8 x 4 position was $3,844.
Now
Since the date of the original article, AAPL rose slightly higher for a few days and has since fallen from a high around $640 to a low around $560. The current risk curves for our position appear in Figure 2
Figure 2 – Current risk curves for May 610-560-510 OTM Put Butterfly
As you can see this position presently is showing a profit of about $1,700 or roughly 45%. There is a bit of a conundrum however. As you can also see in Figure 2 the profitability of this position has nowhere to go but:
- Down (if the stock moves appreciably either up or down in price)
- Up (if the stock remains relatively unchanged as May option expiration approaches).
Now in the typical option lesson the next sentence would read, “If you think the stock is going to move sharply up or down, do [one thing]. However, if you think the stock will remain in a range do [a different thing].” Now this little bit of advice is all well and good except of course if you are like me and you find yourself saying “I don’t have the slightest idea where the stock will go between now and May expiration.” This leaves us with a difficult choice.
Now What? Part 1: Take a Profit
One possibility is to “take the money and run”, i.e., close the position and take our profit. As this is written that would involve taking a profit of about $1,700, or 45% in 20 days. Not bad. But still, if you look again at the risk curves in Figure 2 you will note that the maximum profit potential at expiration is over $16,000. So that certainly seems like a lot of money to “leave on the table.”
Now What? Part 2: Lock in a Profit
One thing about options is that there are always a lot of, well, options available when it comes to adjusting a trade. So let’s consider one other course of action:
We will close 75% of our position by:
-Selling 3 May 610 puts
-Buying 6 May 560 puts
-Selling 3 May 510 puts
This will leave us with the risk curves that appear in Figure 3.
Figure 3 – Risk curves for Adjusted Position
The good news with this new position is that we cannot lose money no matter if the stock goes way up, way down, or anywhere in between. A plan of action between now and May expiration might be:
-As long as the stock stays between 510 and 610 we will hold the position, as time decay works in our favor.
-If the stock trades above 610 or below 510 we should close the position and take our profit.
Summary
So let’s review what we might have learned so far:
-It is not a good idea to bet the ranch and attempt to sell short a stock as it is soaring in price.
-Still even the best stocks stop going up from time to time (OK, you probably already knew that).
-Options afford traders the opportunity to play a potential pullback in an up trending stock in a limited risk fashion.
-Once you enter a position, if the stock does what you expect it to (in this case, decline), either take your profit or lock in a profitable position and let the rest ride.
Hey, maybe there is something to this “common sense” thing.
Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”
Optionetics.com ~ Your Options Education Site
NOTES:
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