Weekly Apple (AAPL) Trade January 29

by Mike Scanlin

This is a continuation of a covered call trade we started on December 5, 2012, on AAPL.

We've now had 7 sets of weekly calls expire out of the money on our AAPL position. As of Jan 29, 2013, AAPL is below our Dec 5 purchase price by about 94 points (closed at 458 today). Even though we've lowered our basis between 64 and 78 points by selling weekly calls, the trades are currently underwater.

Here is a recap of what we've done to date (see prior blog articles). We purchased AAPL at 551.57 on Dec 5. There were 2 strikes suggested, a 535 and 540, so we are tracking two separate trades.

If you wrote the 535s on Dec 5, this is where you are today:

If you wrote the 540s on Dec 5, this is where you are today:

Today AAPL closed at 458 and your adjusted cost basis is either 473.27 (if you started with 535s on Dec 5) or 487.27 (if you started with 540s). This trade is currently unprofitable.

What To Do With An Underwater Position

We wrote an article on stock repair back in 2011, and the concepts are still valid. First, we have to ask ourselves if we still like the stock. If we were in cash today would we enter a new position in AAPL? For us, the answer is 'yes', so selling the position and taking our loss is not something we would consider at this point.

Therefore, choices on next steps include: (1) wait for it to come back a bit before selling more calls, (2) sell new calls without regard to our adjusted basis so we can keep the income coming, (3) sell new calls above our adjusted basis so we won't get locked into a loss if called, (4) buy more stock to average down our cost, or (5) do a ratio spread and try to turn a losing position into a break even or slightly profitable position.

We Are Choosing To Wait And See

After today's action (up 8 bucks) AAPL has had a 21 point bounce off the intraday low of 437 last Friday (when our 520-strike options expired out of the money). Because we are long-term bullish on AAPL we are going to wait for now. If AAPL goes up another 10 or 20 points we'll continue selling weekly calls on it with strikes above our basis (and will post those trades as they happen). For now, we are sitting tight.

Meager Premium For Above Basis Call Selling

If you want to sell out of the money calls that are above your basis then: (1) If you started in the 535 group on Dec 5 your basis is 473.27 so sell the 475 strike for the Feb 8 expiration (10 day trade, get about 2.40 for the call), or (2) If you started in the 540 group on Dec 5 then your basis is 487.27 so sell the 490 strike. Won't get much for it (80 cents) but you can sell additional options in coming weeks.

Ratio Spread Option

This is a zero-cost strategy that will lower your break even point. The idea is to buy 1 call and then sell 2 calls to pay for it. Because you already have 100 shares, both short calls are covered (one by the 100 shares and the other by the long call you buy).

Let's take the case where your current adjusted basis is 473.27 and the stock is currently trading for 458. You buy 1 call with a strike of 460 and sell 2 calls with strikes of 470. For the Feb 15 expiration, you'll pay 9.20 for the 460 call and receive 5.35 for each of the 470s, so you get a slight credit (5.35 + 5.35 - 9.20 = 1.50).

Your new break even price is the mid-point between your (adjusted basis + credit you received) and the strike of the call you bought, or 460 + ((473.27 - 1.50 - 460) / 2) = 465.88. If AAPL closes at 465.88 your 460 call will be worth 5.88 (you sell it); the 470s you are short expire worthless, and you can sell your stock for 465.88 (a 5.89 loss offset by the value of the long call). In effect, you have lowered your break even from 473.27 to 465.88 by Feb 15.

If AAPL is below 460 on Feb 15 then all options expire worthless but because you received 1.50 credit for the trade your new adjusted basis on the stock is (473.27 - 1.50) = 471.77.

If AAPL is between 465.88 and 470 on Feb 15 then your profit is 2 * ((closing price on Feb 15) minus 465.88).

If AAPL is above 470 on Feb 15 then your profit is 2 * (470 - 465.88), or 8.24. That's the best you can do with this strategy (make $824 per 100 shares), even if AAPL goes to 600 by Feb 15 because whatever you make on the long stock and long call is offset by the 2 short calls.

Not the easiest strategy to get your head around. But work out the 'what-ifs' in a spreadsheet and you'll see how it lowers your break even point for an underwater position.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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