Apple's IPhone, An Investors Dilemma

By: Hans_Wagner

Apple has helped investors beat the market this year. The company's iPhone is one of the biggest events of the year for many investors and those interested in the potential of a “game changing” device. Any investor who bought Apple's stock in that recent past has enjoyed a very nice appreciation, partly due to the anticipation that has built up around the iPhone. The question for investors is do I hold on my Apple stock, or do I sell it before the iPhone is released for sale 6pm local time on June 29, 2007. Let's see if we can help put some perspective on this issue.

iPhone Hype

In case you haven't heard about the iPhone here are a few points to consider. The iPhone will be available from the Apple Store and from AT&T Wireless , formerly Cingular Wireless, with a price of US$ 499 for the 4  GB model and US$599 for the 8 GB model, based on a two-year service contract. Apple intends to make the phone available in Europe in Q4 2007 and in Asia in 2008.

Management at Apple expects sales of the iPhone to reach 10 million phones by the end of 2008. PiperJaffray, an investment bank, expects Apple to sell $15 billion in iPhones by 2009, more than the $13 billion in MAC computer sales.

Then there are the detractors who say the iPhone is overpriced and will not play well in the smartphone markets. These people are extensive users of email on their devices and many analysts do not believe the iPhone will be a viable email device.

On the other hand, the iPhone could prove to be the device that the next generation of mobile web users wants, a device that handles web pages and video better than current products. Walt Mosberg, a journalist who reviews technology for the Wall Street Journal tested the iPhone for two weeks in cities across the U.S. You can read the review here . Basically he says the iPhone is a “breakthrough” handheld computer that has some limitations, especially the AT&T network it uses. However, it will automatically switch over to any available Wi-Fi network it finds giving it excellent Web browsing speed.

The point of all this is there is a lot of hyped up expectations regarding the iPhone and Apple's stock. This could be good or bad for investors.

Investors' Dilemma

The dilemma investors face is do they sell Apple's stock before the sales of the iPhone begin, or do they hold on counting on the hype to drive the stock higher. There is an old axiom on Wall Street “Buy on the rumor, sell on the news.” The idea is when the news comes out the price of shares will fall. But what if the iPhone lives up to the hype and the price of Apple takes off with it. In this case Apple shareholders will miss out on the increase in the price of the stock.

So we return to the question “Do I hold on to my Apple stock or do I sell it before the iPhone goes on sale?” If only there was a way to hedge your bet on Apple. In other words, protect your investment on the down side; yet take advantage of any up move if it takes place. Well, it turns out there is a way.

Protect Current Profits

First, you can use a stop loss to protect your shares from a more than expected fall in the price of the stock. But what if you want to keep you Apple shares, since you believe in the longer term for Apple? Also, you are concerned that your stop will be hit on an initial drop in price and then the price of the shares will jump back up. If this happens you no longer have a position in Apple and your shares have been sold at a lower price.

Another way to protect your stock position in Apple is to use a Put Option. A Put Option gives the owner of the put the right, not the obligation to sell the shares of the underlying asset at a set price. An example will help to explain this strategy. First, let's say you own 100 shares of Apple (AAPL) that you acquired at $90 a share earlier in 2007. The price as of the close on June 22, 2007 was $123.00 giving you an unrealized gain of $3,300. Your stop is set at $110, meaning if the bid price hits $110 your shares will be sold for about that price depending on when it is executed. This would leave you with a profit of $2,000. Still a good trade, but you did leave some money on the table, and if you want to own Apple going forward, you must buy the shares again, hopefully below the $110 price level. 

On the other hand let's say you bought a Put Option with a strike price of $120, just below the current trading price. This gives you the right to sell your Apple shares at $120, no matter where the price of the stock goes. If it drops to $110, you could sell your shares for $120, so in a sense the put option acts as a stop loss. You can also sell your put option before it expires to cover the drop in the price of the shares. However, there are some caveats that you need to consider.

First, every option has an expiration date, the date when the option contract ends. This creates a time value factor to the put. Time value is basically the risk premium that the option seller requires to provide the option buyer the right to buy/sell the stock up to the date the option expires. It is like an insurance premium of the option; the higher the risk the higher the cost to buy the option. It is directly related to how much time an option has until it expires as well as the volatility of the stock.

The next factor to consider is you must pay a price to buy the put. As of the close on June 22, 2007 the price for the120 strike price put with an August 2007 expiration date was $6.00. Since you have one hundred shares this means you must pay $600 ($6.00 * 100) to buy a put. For that $600 you get the right to sell your 100 shares of Apple at $120 up until August 18, 2007. If the price of Apple falls to $110 you can sell your shares for $120, giving you a $2,400 ($3,000 profit on the shares minus the $600 to buy the put) profit on your trade when the cost of buying the put option is included. A nice trade, and $400 better than just using a stop loss at $110.

But with your put option you have another choice. You could sell you option before it expires and reap any gain to add to your overall profit. Plus you would still own your 100 shares of Apple. If the price of your Apple shares fell to $110, the price of the August 2007 120 put would rise to at least $10 (the difference between 120 strike price and the $110 price of the Apple stock). For this purpose I am ignoring the impact of the time value factor of options. So if you sold your Apple 120 August put options at $10 you would receive $1,000 and still own your Apple shares. This gives you a realized profit of $400 ($1,000 - $600) and an unrealized profit of $2,000 on the Apple shares you still own. In this case you are better off, as long as the price of your Apple shares do not drop any further. To that end, you should hold your put until the price of Apple has found support, as that is usually the best place to exit this position.

All listed options in the U.S. expire on the third Friday of the month of the option contract. Investors using options need to be aware of the option expiration date. By owning an option you are betting that the option will become profitable within the time frame set by the option. Should the option you acquired become profitable, you can only realize this profit by selling the option. However, you must sell (close out the position) before the option expires. On the other hand, if the price of the stock goes against the option, then the loss of the premium may be acceptable, similar to the cost of insurance. After all, the price of the stock has risen.

There is a way to help pay for the cost of the put you bought to protect your Apple stock position. Sell another type of option called the Covered Call. A call option gives you the right, but not the obligation buy shares of the underlying asset at a set price. A covered call means that you own the underlying asset, so you can fulfill your obligation if necessary. Using our Apple example let's say you believed Apple could continue to rise further, possibly as high as $140 a share by the end of 2007. It turns out that the January 2008 140 call option is selling at $9.20 as of the close June 22, 2007. By selling this option you receive $920 ($9.20 * 100) in cash. Keep in mind that you are now obligated to sell your 100 shares of Apple at $140 per share should they be called. Should this take place you would have a $5,000 profit from your originally Apple buy. In addition you would have $320 from your option trades ($920 received for your Call Option minus $600 to buy your put option you bought to protect against a move down on your shares of Apple). This gives you a total profit of $5,320.

This strategy is called a collar trade. Now remember that an option may expire before the price of Apple's stock completes its pull back. Should this happen you will need to close out the current option contract (selling the put option, and possibly buying back the call option). You can always set up a new collar trade with new strike prices and expiration dates.

The Bottom Line

When the company of a stock you own is about to encounter a news event that is likely to cause substantial volatility in the price of the stock, investors need to evaluate what they intend to do with their stock. A variation of an option collar trade is a way to protect your shares on the down side while giving you a way to pay for the cost of the insurance. Consider using the collar trade when a company is about to announce their earnings or make a significant news announcement. 

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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