Thursday, March 06, 2014

AAPL Mar 3 Short Risk Reversal

AAPL Mar 28 Expiration - Short Risk Reversal (Synthetic Long Stock)

Premium spiked last week with the VIX rising to 16. During the general market sell off, AAPL showed relative strength being slightly up during the day of a strong down market. I also sold weekly VIX cash options at the 19-20 strikes to take capture some of the premium. I will be exiting that trade this week.

Near term, AAPL has declined back under 530 where it has previous bounced with significant strength. This seems like an opportunity to get long the stock the in a synthetic way. Historically, March and April can show general market strength right before the equity markets tend to sell off or stall in May.

Stock - AAPL is expensive. At $500-520/share, 100 shares will tie up 50000 to 52000 in cash or 1/3 that on margin.

Calls - AAPL calls are also expensive in absolute dollar terms. Forgetting about volatility (and theta risk) for a moment, near term unhedged ATM calls can tie up significant capital and have significant positional delta/gamma risk.

Strategy - As we've done before, we can get effectively get long AAPL via a synthetic position that can often be initiated for near zero debit.  Because AAPL is expensive and exhibts a fair degree of movement, the one thing that can be certain is that over a given period of time the stock will move. This provides the opportunity.

To recap, a risk reversal is equivalent to a short stock position. It can be used to lock in gains synthetically against long stock, neutralizing the position. 

Being long a risk reversal position is comprised of being short calls and long a put at the same strike. Being short a risk reversal is selling this position, which results in being long a call and short a put. Therefore the logic is that selling risk reversal is a synthetic long stock position.

** Collar traders will recognize the risk reversal synthetic as locking down the collar against further losses and gains.

Opening Position

Monday Mar 3
Market opens the week selling off on some news. All news for the record is completely irrelevant in my opinion.

This is opportunity.  We place an order in the market for short risk reversal with the following components.

Long Call Spread Mar 28 537.50-542.50
Short Put Spread Mar 28 520-515
These two positions are placed for a limit order at 0 debit (excl. commisions).

The resulting risk graph will look as follows. Notice from 520 to 537.5 the position is flat at expiration. Since the position was initiated, the market has moved up creating a profit as shown by the current risk curve with 23d to expiration. The risk is capped to the downside at the 515 strike and the reward capped at 542.50 to the upside.

The graph is per contract.  The original position has 5 contracts per spread.  Max risk is $2500 below the 515 strike.


Adjustment #1

Thursday Mar 5 - AAPL closed at 532.55, about 7 up from the inital entry price.  We can explore some adjustments to reduce risk and lock in some profit.

At the open AAPL is trading around 532.  To start to hedge the position and lock in some profit, the following adjustments were entered. The resulting risk graph for the position at expiration is now:

Sold the 542.5-545 Call Spread (5 times)
Buy the 522.5-520 Put Spread (5 times)

For a net debit of 0.50 (0.10 per contract)

The spreads sold and purchased are 1/2 of the original position width leaving upside potential and some downside risk. I am still looking for AAPL to make modest bullish gains in the next few weeks.

The net position risk is cut to $1300 below the 515 strike (down from $2500), but we still have a kicker to the upside and profit zone to the down side between 522.5 and 517.60 (calculated breakeven).

By end of day the AAPL closed down about $2 to $530. The position is still net theta positive ($5/day), although we now have a lower immediate profit due to the adjustment.

Looking forward, we have some protection to the downside along with a fairly decent profit zone (516-522.5).  Should the stock make another run to the upside we can look to make more adjustments by selling more 2.5 strike width call spreads, closing part of the short put position (which would be profitable due to buillish movement and theta decay), or some other combination.


Adjustment #2

AAPL spiked up near the 537.5 strike.  This bullish move presents an opportunity to adjust the trade once again, locking in some profit and reducing risk.

Right now the trade is up nearly $400 on 5 cts, but the center part of the risk graph is just below 0 at expiration, so this amount is at risk.  Further, there is a maximum risk of $1300 to the downside.

The adjustment will be to sell 5 cts of the 537.5 - 540 call spread to collect more premium. We will loose some of the upside potential, but end up lifting the risk curve overall reducing total risk. We are not expecting the stock to completely run away to the upside but continue a gradual movement upwards.

Sold 537.5 - 540 Call spread (5 times)

For a net credit of 1.15

The result is a 5 point butterfly at the 540-542.5-545 strike.  There also is a locked in profit of $525 above the 520 strike. The max risk has also been cut to $750 with a breakeven around 516.

The risk curve is looking good as we have a wide range of profit, no upside risk, and have cut the downside risk by half.

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