Apple Options Flash Warning Sign

02/22/2012 9:00 am EST

Focus: TRADING

Dan Sheridan, contributor to InvestorPlace.com and founder of Sheridan Mentoring, explains why Apple stock may be in the danger zone.

America’s favorite pastime used to be baseball. But during the last couple of years, that has changed. The new American pastime has become to get long Apple (AAPL) any way you can, and wait for the profits to accumulate.

Over the last two years, AAPL has skyrocketed from around $190 to $500—simply staggering! Since June 20, AAPL has run from $315 to its current level of $514—that’s a meteoric rise of 60% in just eight months!

Let me say that one more time: a 60% rise in eight months! You don’t often see that kind of movement, in that short of a time frame, in a stock that’s trading in triple digits.

So why shouldn’t it continue? Actually, this is dangerous territory for Apple and for AAPL perma-bulls. Here’s why.

Strange Volatility for a Soaring Stock
Over the last two weeks, AAPL has shown a changed personality that you should be aware of. This personality is much different than the fun-loving, “get on my back, and I’ll take you up, up, up to always-higher stock prices.”

From a psychological perspective, this personality change started a little over two weeks ago, around February 3. AAPL was trading at $460, and the March at-the-money implied volatility was around 19.

What does that mean in English, Spanish, and Portuguese? It means everything was OK, and no real fear of the downside was cropping up. But was it?

Meanwhile, the speed to the upside was really picking up. From November 25 to February 3, AAPL went from $363 to $459, 26% in a little over two months. Everybody wanted in!

On February 10, AAPL hit $493, and the March at-the-money implied volatility in the calls spiked to 27. What’s the big deal? Well, option volatility usually decreases on the upside as prices go up and fear of the downside tends to dissipate. And remember, this is AAPL—this is America!

But then last week, the personality disorder got much worse. As AAPL climbed a bit higher to $500, the March at-the-money option volatility climbed higher to 32 in the calls. That is an increase in two weeks from a 19 implied volatility to 32, an increase of 68% with the stock rising.

What does this mean to you? Well first, let’s look a little more closely at why there’s so much volatility in AAPL options right now … and what you can do to protect yourself and even turn a profit!

Why are the option volatilities in AAPL going up? The simple answer here is speed!

Look at a pivotal day: Wednesday, February 15, when AAPL traded intraday to $526 and closed at $497. That’s a decrease of 5% from the daily high to the close. The stock’s rate of speed up and down intraday really picked up in both directions, which said that sellers were coming in a bit!

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The last time I really saw this kind of speed to the upside was the Internet debacle many years ago, when stocks were screaming to the upside. Do you remember what happened after they went up so fast? (The phrase “tech wreck” probably comes to mind!)

What does increasing option volatility mean to the retail trader? It means the green light on the stock may possibly be turning to yellow, and you should exercise a bit of caution.

Does this volatility news mean I can’t stay bullish on my beloved AAPL? No, it just means how you get long may need to change. This leads me to the options trading strategy for today, if I want to be long AAPL but be cautious.

How to Profit from AAPL’s Personality Change
With this disturbingly changed personality in AAPL the last two weeks, I would approach any bullish trade very cautiously and make sure the risk-reward looks acceptable to me.

In other words, if AAPL nosedives, I’m very comfortable with my total downside risk. I would initiate the below strategy after one to two down days.

With the stock trading at $502.50, you can buy 1 AAPL March 500 Call and sell 1 AAPL March 505 Call for a net debit of around $2.40 ($240 per contract). This strategy, called a vertical debit spread, allows you to play a high-priced stock for a very reasonable cost.

It doesn’t matter what you pay or collect for the individual legs of the spread, as long as your final price is around $2.40 to enter the trade.

In this call option trade, we are actually selling an option (the March 505 Call) with more time premium than we are paying for with our long (the March 500 Call). This is good considering that option volatilities (i.e., implied volatility) have skyrocketed the last few weeks.

The risk-to-reward ratio is about 1:1, meaning we can make $250 profit potential with a maximum risk of $250.

If the stock is trading at $505 or higher at expiration ($2.50 higher than the current $502 level), you can make 100%. This again is a cheap way with limited downside risk ($250) to play a very expensive and volatile stock.

Dan Sheridan is a contributor to InvestorPlace.com and founder of Sheridan Mentoring.

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