Hey, how’s that for equivocating on what could have been an extremely provocative, bombastic, attention-grabbing headline? Not bad, eh? So am I calling for not only the top in AAPL but also an end to their business as we know it? Sorry, I don’t make those kinds of calls. In this case, I am speaking strictly in the short-term countertrend trading sense. In Figure 1 you see the price of AAPL has doubled over the past nine months.
So am I invoking the age old “what goes up must come down” doctrine? Again, in a word, “no”. In reality I should probably have titled this piece “Apple Price Diverges in a Rarely Scene Extreme Way from one of Jay’s Favorite Short-Term Momentum Indicators Thus Suggesting That it May be Possible that a Short-Term Top Could Occur Sometime Soon.” But I am afraid that if I post a title like that I might crash the entire Optionetics website. Hence the reason I chose to go with the equivocating yet provocative, bombastic, attention-grabbing “Apple is Toast (Well Maybe, Sort of)” headline.
Figure 1- AAPL stock: All appears to be well
So with that all cleared up let me show you what I am actually talking about.
Behind the Curtain
Everyone looks at price action because, well, that’s where the action is, so to speak. And that is the only real measure of whether you are making or losing money. But price movement is often a function of momentum. A stock will thrust to higher ground and attract more interested buyers in the process. As more investors are drawn in and jump on the bandwagon the upward momentum continues. But eventually – behind the curtain, or if you prefer, under the radar – certain signs often begin to emerge to suggest that upward momentum may be waning (note the use of the word “often” and the phrase “may be” – we are not talking about hard and fast rules here).
One of my favorite momentum indicators is the 3-day RSI (plotted at the bottom of Figure 2). One thing I look for is situations where price makes three higher highs, but the 3-day RSI actually peaks at a lower levels with the second and third high in price. Often – but not always – this warns of at least an impending near-term top. By itself, this is not necessarily a call to action. A countertrend position should only be taken if other bearish signs emerge. That being said, the more this divergence between price and indicator continues the more ominous the warning sign. And eventually, this divergence between price and the 3-day RSI can be taken as its own bearish signal.
Case in point: AAPL
AAPL Price/Indicator Divergence
In Figure 2 you can see that in mid-February, AAPL hit a new high and the 3-day RSI topped at 99.6. Since that time, AAPL has registered 5 more new price highs (not the green arrows in the top clip of Figure 2). Now look at the action of the 3-day RSI in the lower clip. On each occasion that price made a new high, 3-day RSI peaked at a lower level than the previous peak. A “threefer” often signals something meaningful. This one is a “sixfer(?)”.
Figure 2 – AAPL price making repeated higher peaks, 3-day RSI making repeated lower peaks
So does all of this mean that AAPL is in fact “toast”, and that we should all be selling short as many shares of AAPL as we can get our hands on? Not necessarily. I typically look at situations like this as an opportunity to consider a relatively low dollar risk option trade to take advantage of a potential short-term correction (with the understanding that I may well be wrong and thus will need to put position management steps into place – more to follow).
There are many ways to play a potential short-term pullback in AAPL. One possibility is a “bear call spread” which involves selling an out-of-the-money call option and buying a further out-of-the-money call. As long as the stock does not rally sharply to new high ground this strategy can generate a profit. Another possibility might be a “bear put spread” which involves buying a slightly out-of-the-money put option and selling a further out-of-the-money put. If the price of AAPL declines this strategy can offer very favorable reward/risk potential. One other possibility is an out-of-the-money butterfly spread (or OTM Butterfly). Let’s take a look at one example that involves:
-Buying 1 May 610 put
-Selling 2 May 560 puts
-Buying 1 May 510 put
Figure 3 displays the position and Figure 4 displays the risk curves. Statistically, a one standard deviation move lower by AAPL would result in a decline to $568 a share between now and May option expiration.
Figure 3 – AAPL May OTM Butterfly
Figure 4 – Risk Curves for AAPL May OTM Butterfly
A couple of things to note as of the time this is written:
-The maximum risk on this position is $961.
-If by chance AAPL declined one standard deviation by May expiration the profit potential is in excess of $3,000.
Now let’s look at this from a position management point of view:
-If AAPL starts to rise we should consider exiting this position if the stock hits $650. Up until 15 days prior to May option expiration this would result in a loss of somewhere between $375 and $610, depending on whether AAPL hits $650 sooner or later.
-If AAPL stock is above $600 two weeks prior to May option expiration we should consider exiting the position in order to avoid the potential for time decay in the last two weeks (notice how the black line – which represents the profit or loss as of May option expiration on 5/18 – moves sharply to the negative side above $600 a share).
-Although it does not appear in Figure 4, the risk curves will start rolling back to the negative side if AAPL falls below $560 prior to expiration. So if AAPL does by chance hit $560 prior to expiration we should exit this position and take a profit.
-Lastly, in a magical world, AAPL will close at exactly $560 a share on 5/18 and this position will realize its maximum profit potential of $4,039 (um, don’t hold your breath).
One advantage of trading options is the ability to take advantage of opportunities that you might not otherwise be able to. To wit, I would never suggest that a person sell short shares of AAPL stock simply because of a divergence between price and the 3-day RSI. There is simply too much risk and a very large capital requirement involved.
Nevertheless, as you saw in thee example above it is possible to enter a position that can make a pretty decent rate of return if AAPL does pull back in the near-term, with an expected worst case risk (if AAPL hits $650 on or before 5/3/12) of about $600.
This type of trading may not be everyone’s cup of tea, but if you are considering “expanding your horizons” a bit, it’s a good place to start looking.
Staff Writer and Author of “Seasonal Stock Market Trends”
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