High risk, high return trade on Apple iphone 5 launch

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Two weeks ago we outlined a strategy to take advantage of the expected increase in Apple (AAPL) implied volatility (IV) and realized volatility – ie large stock moves – before the expected iphone 5 launch, using a medium term at the money (ATM) straddle.

This was successful – we made a 14% gain in about a week – but it was quite a conservative trade. Today I want to go through a much risker, but potentially more rewarding short term strategy to trade the same event, now confirmed to be Wednesday 12 September.

(OK, there has been no confirmation that the event is the new iphone launch but I think one of the easiest bets to make right now is that it is – which we shall assume for the purposes of this article).

Trade rationale

Apple is heavily dependent on its iphone product line. What I said in the article of the AAPL straddle is still true:

58% of Apple’s Q2 revenue came from the iphone (and related products and services), which for perhaps the first time has real competition from the likes of the Nokia Lumia/Windows 8 and Samsung. A successful iphone 5 launch is therefore vital if the current positive market sentiment is to continue.

This ‘positive market sentiment’ has continued since the article was written: the stock has risen another $30 to $680, $150 above its May low of $530.

We believe that a successful launch will further strengthen the stock, potentially pushing it above $700 and beyond. There is just so much money for Apple to make over the next few pre-holiday months meeting the pent up demand for an attractive new iphone, that a successful launch should give AAPL even further support.

The risk

However there is, of course, a risk that the launch is not successful. Indeed such has been the success of previous launches, and the company’s ability to innovate, that there is a danger that anything less than a game changing iphone release would be seen as a failure.

Also it could be argued that a game change is already baked into the share price: that $150 stock increase. A stock priced for perfection could be punished severely by anything less than a perfect launch.

Furthermore there is the ‘buy the rumour, sell the fact’ phenomenon. Often stocks expecting good news rise before its announcement only to fall back as the news is confirmed. And so even a good release could cause the stock to fall, or at least stagnate.

We think not, given the history of Apple launches, but any trade we put on needs to mitigate this risk. We should not be significantly exposed to a fall in the stock.

The trade

We want to design a trade that does very well (we want to have a high reward for success given the risk) if AAPL makes a significant move upwards, but is protected on the downside. We only want to put this trade on until just after the launch (ie 3 days) and so there is more scope for using weekly options due to low theta risk.

A trade we advocated before in another context (trading VXX spikes) – the call backspread – is a great choice. We will put the following trade on:

• Sell 1 14Sep12 700 Call
• Buy 2 14Sep12 710 Call
• Cost: $8 (i.e. effectively zero)
• Stock price: $680.44
• Margin: $1,000

Below is the payoff diagram:

The red line is at expiration (Sep 14). As can be seen the risk of the trade is significant: up to $1000 should AAPL be $700-$720 on that date.

However we can mitigate this risk by taking the position off early. The black dashed line is the P&L on Sep 12. As we can see most of the risk isn’t apparent then. Therefore, as long as we take the position off on 12 Sep, after the launch (which starts at 10am PT), we should be reasonably safe. The breakeven is approximately $705 on the upside.

As ever, though, we will take the trade off if we have lost 2% of our total capital. In Epsilon’s case we will do 10 spreads – at a total margin of $10,000 – and will take the trade off if we lose 2% of our $100k capital (ie $2,000).

Again the call backspread is great for betting on a significant upwards move in a short timeframe, whilst limiting the risk. The iphone launch provides an opportunity for just such a move; but we are protected should this not occur.

Diversification of risk could be provided by having a portfolio of such backspreads on potential winners and losers from the launch (GOOG, NOK, QCOL etc). Risk is limited for losers; reward is maximized for winners.

However I will leave that to those of you with good knowledge of these stocks and their potential Sep 12 reactions. We are sticking to just this trade. Here’s hoping for one of those classic Apple launches; and stock surges.

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