Will You Trade Apple Earnings Like Warren Buffett Traded Burlington Northern?

Apple (AAPL) is scheduled to report earnings on April 24th. I have already shared some interesting things about this quarter that you may want to read before playing Apple earnings (Please read to get on-board).

So, assuming you want to trade AAPL earnings, you need to answer following (for this earning announcement only) –

1. Are you Bullish?
2. Are you Bearish? or
3. Are you Neutral and don’t care whether Apple drops or goes up after earnings, but you still want to trade without a directional bias?
4. How much will Apple move? Whether bullish, bearish or neutral, you need to decide how much Apple can move. For this article, I shall assume that Apple might move +/-$40 (this doesn’t mean that I think it will move by $40)

Let’s discuss the the BULLISH case.

This assumes that you are an Apple fan, you believe in the company and you want to add to your previous purchases. You are a long term investor. You are in no hurry though.

You could do it via followings-

1. Buy 100 Apple shares @ $573, your investment risk is $573×100= $57,300; If Apple goes up $40, you make 40×100=$4,000 i.e. $4,000/$57,300= +6.98%; if it drops $40, you lose $4,000 or -6.98%. But since you are a long term investor, you don’t really care for short-term “fluctuation” because you know Apple business is worth more than $573/share and you have enough margin of safety at $573.
2. You can buy ITM, ATM or OTM weekly, next month, or LEAP call options to lower your cost. For simplicity, let’s assume purchase of only 1 contract of May’12 $500, $570 and $640 calls which costs $7,980, $3,120 and $865 respectively (as of Friday April 20, close). Assuming post earnings, Apple goes up $40 and IV drops by 10%, the $500 call be worth ~$12,000, $570 call will be ~$5,200 and $640 calls will be worth ~$1,500 (post earnings) and ~12,000, $4,300 and $0 respectively on May 18th expiration close. By playing via call options you are leveraging your capital. As you know leverage is a double edged sword. So, if Apple drops by $40, the leverage will work against your trade, incurring greater losses.

There are many others option strategies to go long but for now let’s focus on these two popular ones. Clearly both the strategies have their own advantages and disadvantages.

Here is the 3^rd alternative,

Go long via selling put.

As a primer, you may want to read a simple yet very effective article on Selling puts on AAPL by Bill Luby. For most traders, naked put selling is a big no-no. On one hand, retail public is scared of selling naked puts but on the other hand they are more willing to covered call writing. Do you know Cash Secured Put selling is synthetically same as covered call writing! Allow me show you how.

Covered Call

1. Buy 100 AAPL Shares @ $573, Cash Flow (Out) = $57,300
2. Sell 1 May’12 520 call @$62.40, Cash Flow (IN)= $6,240
3. Overall Breakeven price by May expiration = ($57,300-$6,240)/100= $510.6

Cash Secured Put

1. Sell 1 May’12 520 Put @ $9.30, Cash Flow In = $930
2. If Assigned @$520 on May Expiration, Cash Flow Out= $52,000
3. Overall Breakeven= ($52,000-$930)/100= $510.7

I have chosen $520 strike as an arbitrary number. You may calculate using any strike you like. The resulting breakeven price for covered call and put selling strategy will be the same for the same strikes.

(For simplicity, I have not included impact of portfolio margining etc. which will increase the yield further).

Now let’s compare all the 3 alternatives’ performance on May 18, 2012 (Assuming AAPL is either $613 or $533):

1. Buy shares: P&L +/- 6.98%
2. Buy ITM ($500), ATM ($570) or OTM ($640): P&L are possibly +41.6%/-58%, +37.8%/-100%, -100%/- 100%
3. Sell Cash Secured May’12 520 Put: +1.8% in either case ($930/$51,070= 1.8%)

Though yield for #3 can be increased by modifying the strategy further, let’s keep it simple. I shall discuss that in another article.

Watch-out: While this strategy may sound simple, you need to make sure you can hold your position till May’12 expiration. Whether you do it via covered call or cash secured put, your upside potential is limited. Till May’12 expiration, if however Apple continues to go down, puts will increase in value (thus your losses will increase too). The puts will be worthless only if Apple is at or above $520 on May 18th

So why do it? You may want to benefit from unusual uncertainty (thus high implied volatility) thus lowering your eventual purchasing cost of shares. This naturally assumes you are ok with losses, if Apple drops, as you would be with the shares.

When we think of Value investing, Warren Buffett’s name comes to the mind. Do you think Warren Buffett doesn’t trade options? Think again! BERKSHIRE HATHAWAY sold Puts on Burlington Northern Railroad!! Here is the table with actual SEC filings for those transactions.

(Click on dates to see actual SEC Filing)

Why did he do that? My guess is that during October 2008, markets were in panic mode, implied volatility was rising and hence options’ premiums were really expensive. Being someone who has been selling insurance premium for almost all his career, this was, in my opinion, a wonderful opportunity for him to lower the cost of his eventual purchase.

The opportunities do exists time and again. Risk- free, at times.

Once Warren Buffett announced that he purchased BNI for $100 (cash and stock), BNI shares rallied but were still trading for less than $100 because of uncertainty. Together with OPNewsletter subscribers, we jumped on the opportunity and profited almost +56%.

So if you want to go long AAPL, why not take advantage of the opportunity of high implied volatility, trade it like Warren Buffett, and reduce your purchasing cost. Won’t Apple at $520 be cheaper than Apple at $573 or $644?

(if you would like to join for OP Income Newsletter, please click here)

Profitable Trading, OP

Additional disclosure: Option trading can be risky, and you may lose your capital quickly if not done properly. Please do your due diligence before investing any money based on above. This article is for informational purposes only.