Tuesday, December 18, 2012

Morning Update

Yesterday the market closed on the highs of the day in a follow through move from Friday’s reversal. The eMini S&P 500 futures punched through the technically significant 1420 level with relative ease, and it looks like momentum is on the bulls side for the near term. However, the market will continue to be driven by every word out of Washington on the fiscal cliff. The latest developments in the negotiations seem to show a deal is getting closer, but we will believe it when we see it. Boehner is due to meet with House Republicans at 9 EST and a press conference is scheduled shortly after.

Apple, the world’s most valuable company, has seen some huge intraday ranges the last few days. This has sent historical, or realized, 20-day volatility near its 2012 highs and implied volatility near levels typically only seen just before an earnings announcement. This, combined with expectations of light trading through the holiday season, has many option traders selling out of the money AAPL options. One trader sold 512 Jan. 630 call for $1.19 and bought 512 Jan. 640 calls for $0.99. This creates a bear call spread, which is a fixed risk, fixed reward trade that profits if AAPL is below 630 at expiration. The maximum risk in this trade is $9.80 and maximum reward is $0.20.

This trade has a very poor risk reward profile since its maximum profit is only 2% of its maximum risk. However, given current implied volatilities in AAPL, this trade has an approximately 97% chance of profitability since the 630 strike is about two standard deviations from yesterday’s close. There are 31 days to January expiration, which gives this trade an annualized return of 16%. While this may look tempting to many investors, it is important to remember that AAPL has been known to make two standard deviation moves, especially in the past two months.

By selling an out of the money call spread this trader is expecting AAPL to be range bound between 500 and 600 through January. Personally, I bought AAPL at the money AAPL calls when I saw the stock following through off it is lows yesterday. I am looking for momentum to continue driving its short term bounce and will be quick to take my profits if the stock begins to look range bound. d is one play to consider. If you are bearish to neutral on AAPL then go with the bear call spread, and if you are bullish to neutral, go with a bull put spread.

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