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Getting Ready To Strangle Apple

  • July 24, 2007

If the 2000-2003 bear market was one of the longest bear markets in history, this resilient bull market, which has now lasted over 52 months also happens to be one of the longest bull markets without a meaningful correction. It is getting harder and harder to find good opportunities whether you look at different asset classes (stocks, bonds, real estate, commodities, etc.) or in geographically diverse locations. Without insinuating that we are in the midst of a global bubble (the euphoria that usually defines bubbles is largely missing), I can say from experience that it is becoming harder and harder to come up with one or two new ideas for the newsletters each month. I am still trying to figure out if I really admire or am perplexed by some stock pickers who come up with ideas almost on a daily or weekly basis.

If you are familiar with options, straddles and strangles, please feel free to skip through the next two paragraphs.

In this environment I have been considering using a certain options strategy that is best suited when you have a neutral market outlook. We have used options in the past to hedge our long portfolio. In contrast, this strategy is a calculated neutral bet on volatility with a slight directional bias. In case I almost lost you with that sentence, let me elaborate further. There are two options strategies called straddles and strangles that allow you to benefit from sharp upward or downward movement of stocks. You do not have to believe that the underlying stock is likely to do well in the future (a bullish/long opinion) or that it will eventually suffer a terrible fate (a bearish/short opinion). All you have to believe is that the stock is volatile and likely to jump in either direction. Hence the best use of this strategy is during a period of general market volatility or when a specific event such as an earnings announcement is likely to make a stock react sharply.

A couple of years ago someone asked me if it was possible to benefit from both going long and short a stock at the same time. While I could understand why this question was asked, the answer was that it was not possible to benefit from such a neutral strategy, unless you used a different instrument such as options on the underlying stocks. In a straddle, you buy both a put option and a call option at the same strike price. For example, on July 18th or 19th when Google (GOOG) was trading at around $550, you could have bought a August 2007 put on Google at a strike price of $550 and a August 2007 call at the same strike price. The idea would have been that you were either expecting Google to report results that fell short of expectations or very good results the following evening and hence a sharp movement in the stock. As it turns out, Wall Street was disappointed with Google’s results and the stock dropped more than $28 on July 20th. At this point, your call option would have been worth close to nothing but your put option would have soared in value as it gave you the right to sell Google at $550 even though the stock was trading at $520. As long as you paid less than $30 for both the call and the put option, you would have made money (assuming the options moved to the same extent as the stock, which is often not the case). If this is not complicated enough, straddles come in two flavors called long straddles and short straddles. You can get all the details about these flavors in this Wikipedia article.

Since near the money options on Google tend to be expensive, to reduce your cost basis and hence your capital at risk, you could have also bought slightly out of the money options such as $560 calls and $540 puts. This strategy is called a strangle. It is this strategy that I plan to use with Apple (AAPL) today but with a slight long bias as I expect Apple to do well in the coming months. Apple reports quarterly results after the close tomorrow July 25th. As I write this blog post, the stock is trading almost $7 or 5% lower today thanks to a comment made by AT&T during their conference call about the number of iPhone activations.

On the flip side I also plan to strangle the maker of the popular Blackberry devices Research In Motion (RIMM) with a slight short bias as I expect Apple’s iPhone to eat into RIMM’s market share and profit margins. After conquering businesses, RIMM decided to expand beyond their core business customer base and target regular consumers with their Blackberry Pearl. I currently use a Blackberry 8700 and can personally vouch for how good the device is for email, checking stock quotes as well as making calls. I also had a chance to play with both the Pearl as well the Blackberry 8800. However when I got my hands on an iPhone a couple of weeks ago, I was totally blown away. The interface is so simple and easy to use that even folks who are not gadget freaks would love this device. Stock quotes with charts, Google maps with traffic overlaid, a video iPod, a Safari web browser that is very usable, a decent camera and Wi-Fi internet access beyond AT&T’s EDGE network – it is hard not to fall in love with this device. I liked it so much that I picked one up for a gift last week.

As for business users, the iPhone offers the ability to get email either through a POP3 connection or directly from an enterprise exchange server similar to Windows Mobile devices like the ill-fated Motorola Q. While RIMM derives more than 75% of its revenue from hardware sales, it does enjoy very good margins from software sales. Blackberry Enterprise Server for Microsoft Exchange with a 20 user limit can set back enterprises as much as $4,000. Once you include this cost, the iPhone almost begins to look cheap for businesses. In fact I noticed the price of the Pearl and 8800 drop significantly a couple of months before the release of the iPhone.

So based on this slightly bullish sentiment on Apple and the slightly bearish sentiment on Research in Motion, here are the options I am going to buy for the InsideArbitrage model portfolio to create the strangles. I am going to purchase the options for Apple right now in order to cover the earnings announcements on July 25, 2007 and will purchase the RIMM options sometime in September to cover the earnings call on September 27, 2007. I will use the market closing price today as the price for these options.

  • 4 Contracts of Aug 2007 $140 Calls on Apple
  • 3 Contracts of Aug 2007 $130 Puts on Apple

Voluntary Disclosure: I do not own any positions in any of the companies mentioned but will buy these options for my personal portfolio after this blog entry is published.