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By: Costas Bocelli — May 21, 2010

Are You a Buyer of AAPL at 180?

As the European sovereign debt crisis begins to intensify, financial markets and most asset classes are being negatively affected.

Risk appetite seems to be waning, and many of the “smart money” players are reducing exposure or unwinding altogether.  The volatile currency markets are a testament to the recent action, as displayed by the Australian Dollar/Japanese Yen currency pair trade.

The volatility index (VIX) is sitting around 46, confirming investor fears.  The S&P 500 Index dropped below the key 1100 level, which denotes the 200 day moving average.  The index will likely test the February lows of around the 1044-1050 level.  This level, ironically, was established when Greece had to come clean when their “real” set of books revealed the dangerous financial economic condition that is plaguing the country. 

The debt contagion has spread regionally across the Eurozone, prompting the ECB, IMF and the 16 countries to put up a $1 Trillion guarantee to protect members from the risk of sovereign default, systemic liquidity risk in the banking system, and to keep government borrowing rates subdued.

These actions have put the Euro currency into a free fall, and have caused extreme volatility and significant selling pressure around the globe.

Although it is uncertain how large the downside magnitude will eventually be -- especially if the S&P 500 trades below its February low -- these are moments where opportunities can arise to capture huge profits and pick up assets at bargain prices.

How can you take advantage of the extreme volatility and fear in a valuable company, such as AAPL?

Apple Inc. (Sym: AAPL) is a powerhouse company that has a red hot product line and makes a ton of cash.  The 52 week high is around $270/share.  Currently, AAPL is trading at 241, yielding a price to earnings ratio of less than 12. 

AAPL is probably a buy right here, but with the macro markets grabbing the leash, even a mighty company like AAPL is not immune to irrational sell offs.  Last time I checked, I don’t think the company invests in European debt instruments.  Never the less, the market does not care during a panic sell-off, and the bids will disappear in a “flash,” sending the stock sharply lower.

Take a look at the chart of AAPL ... 

Would you be comfortable owning this stock at $180 if the markets unwind and AAPL sells off to these levels?  Would you like to make 20 points if AAPL trades down to $200, close to its 200 day moving average?  Would you like to have this position handed to you for free?

If you answered yes to all three of these questions, continue reading.

The options strategy that answers these three questions is called a "ratio vertical spread."  A ratio vertical spread is constructed where more options are sold than are purchased (ratio) in the same expiration month and same type (Put or Call).  The ratio vertical spread can be an effective strategy to take advantage of the elevated volatility and option pricing.

How to construct the position

With AAPL trading at $241, you would want to buy 1 (one) JUNE 220 PUT for 7.00.  This will give you the right to sell the stock at $220.  To complete the ratio vertical spread, you would want to sell 2 (two) JUNE 200 PUTs for 3.50. Selling the 200 PUT strike will obligate you to deliver 200 shares of stock to the owner at $200.  By selling 2 contracts, you will receive a 7.00 credit, offsetting the purchase.  This answers the third question I posed: the trade costs $0.00.

If AAPL trades at $200 at June expiration, you will make 20 points ($2,000) on the 220 PUT while the 200 strike PUTS that were sold will finish worthless.  This scenario answers the second question.

If AAPL continues to fall below 200, you will be assigned to buy at $200.  Remember that you own ONE 220 PUT, so you will get long only 100 shares below $200.  However, you picked up 20 points profit from the move from $220 to $200, so your true break even is lowered to $180/ share of AAPL.  The downside to this strategy is that you are at risk for the rest, from $180 to $0 on 100 shares.

If AAPL never gets below $220 by June expiration, and this debt crisis and selling pressure wanes, remember your cost of the trade: $0.00.  Please note, since you are short 1 extra PUT, margin consideration needs to be accounted for in the trading account.

As a recap, if AAPL is above $220 at expiration, your only loss is transaction fees, since the trade was done for $0.00.  Below 220, the position makes money all the way down to $180, which is the breakeven point.  The apex of profit is at $200 with a 20 point gain.

This strategy should only be considered on specific stocks that are in excellent financial shape.  You would not want to apply this strategy to stocks that could face potential destruction, such as global banks with huge exposure to sovereign debt.

You have to ask yourself, if the stock is put to me, am I prepared to be a buyer at that level?  The question is ... ARE YOU A BUYER OF AAPL AT $180?

QUICK SIDE NOTE:

If you like the downside play, but are uncomfortable with the one extra short naked PUT that technically poses unlimited risk or the margin requirement may be too much of a strain on the account, consider this small adjustment.

You can purchase a 180 PUT for 2.00, basically putting you into a 220 200 180 Long PUT Butterfly.  The most you can lose is 2.00 and the max profit is 18 if AAPL is at $200 at expiration.  (The Butterfly will be worth 20 at 200.)  The breakeven on the position is 218 and 182.  Above 220 or below 180, the loss will cap out at 2.00.

This alternative adds 2.00 in cost, but reduces risk, allowing you to put on a low cost downside position and participate in gains if AAPL falls within the breakeven range.

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