Bullish Call Spread Trade on Apple

08/22/2011 12:24 pm EST

Focus: OPTIONS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

One option trader bet on an upside move for Apple, Inc. (AAPL) by executing a bullish call spread, a strategy that reduced the trader’s maximum risk as well as the overall cost of the trade.

Like the rest of the equities market, shares of Apple Inc. (AAPL) were swimming in red ink last week. Nevertheless, looking at the action in the options pits, it appears one spread strategist—like most of Wall Street—was maintaining an optimistic outlook on the tech behemoth.

Specifically, in Friday’s session, symmetrical blocks of calls traded at the January 2012 380 and 400 strikes. Implied volatility (IV) on the 380-strike call was last seen 2.8 percentage points higher, while IV on the deeper-out-of-the-money call was up 2.5 percentage points at last check, pointing to the initiation of new positions at the strikes.

However, while the 380-strike calls traded at the ask price of $29.37, implying they were likely bought, the 400-strike calls crossed at the bid price of $20.77, hinting at sell-to-open activity.

Simply put, it appears the speculator constructed a long-term bull call spread on AAPL for a net debit of $8.60 per pair of calls ($29.37-$20.77). By doing so, the investor is betting on shares of AAPL to power north of the $388.60 level (bought call strike plus net debit) within the calls’ relatively lengthy lifetime.

However, no matter how far the security should climb beyond the $400 level before options expiration, the most the trader can make is capped at $11.40 per pair of calls (difference between strikes minus net debit) thanks to the sold 400-strike calls.

On the flip side, even if AAPL extends last Friday’s retreat, the most the investor stands to lose is limited to the $8.60 paid to establish the spread.

OptionsIdea-Chart1

But if the strategist has bullish expectations for AAPL, why not just buy the 380-strike calls? After all, had the trader simply purchased the 380-strike calls, their profit potential would be theoretically unlimited, as there’s no limit to how high a stock can rally.

In the simplest terms, while a long call can offer an appealing profit potential, the "vanilla" call buyer would’ve needed AAPL to muscle atop the $409.37 level (strike plus premium paid) just to break even. Plus, they would’ve been out the entire $29.37 paid for the call had the stock failed to live up to the lofty expectations. By simultaneously selling the higher-strike call, the strategist not only slashed their breakeven rail, but also reduced the maximum risk (and initial cost) by nearly 71%.

At last check, shares of AAPL have surrendered more than 4% to linger in the $356 vicinity. In order to rebound and extend its quest for record highs—as per the strategist’s expectations—the stock will have to power atop both its ten- and 20-day moving averages, which haven’t been toppled since August 1.

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As alluded to earlier, though, the options bull isn’t the only member of AAPL’s fan club. According to Zacks, the security has earned 37 "strong buys" and four "buy" ratings from analysts, compared to three lukewarm "holds" and not a single "sell" suggestion. Plus, only about 1.3% of the stock’s float is dedicated to short interest, and it would take less than a day to buy back at AAPL’s average pace of trading.

By Andrea Kramer, contributor, Schaeffer’s Trading Floor Blog

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