Monday, December 10, 2012

A Market Neutral Iron Condor in Apple

Market neutral positions that will profit in a sideways market can provide another aspect of diversification to a portfolio. With last weeks drop in the price of Apple (AAPL), some pundits have suggested this is a buying opportunity for this stock. Another alternative is to use this drop in price as a trigger to establish a market neutral position in Apple. The type of a position that will generate income in a sideways/neutral market, and hence nicely augment a larger portfolio.

With Apple trading around $535 last week one such trade was to
  • Sell the Jan $495 put
  • Buy the Jan $490 put
  • Sell the Jan $580 call
  • Buy the Jan $585 call
After commissions this iron condor trade would generate about a $240 credit per contract. That is the maximum gain on the trade, while the maximum loss is $260 per contract. That pricing indicates that conceptually there is just a little less than a 50/50 chance that the stock will be trading between essentially $493 and $582 by January expiration. Potential outcomes if held until expiration are:
  • Worse case - the stock falls below $493 and the trade loses $260/contract. Basically, the hope is that buyers might be increasingly motivated to come in if the stock were to fall to below the $500 support level. Hence, the $495 strike is potentially a reasonable level at which to risk losing money.
  • Second worse case - the stock rises over $582 and the trade loses $260/contract. The stocks 50 and 200 day moving average will likely be around this level in January. This will potentially provide resistance to the stock rising through this level, and make this a reasonable price at which to risk losing. Further, given its huge weight in the markets, if Apple was to rise this much, it is very likely other more traditional portions of a portfolio will be up as well. Hence losing this trade to the upside can be rationalized as kind of a portfolio hedge.
  • Best case - the Apple bulls and bears keep an equilibrium on the stock, and it trades sideways ( in the $85 range between $495 and $580). This would result in a $240/contract winner!
Of course, this trade does not need to be held until expiration. If at some point time, (i.e. early Jan) the stock price happens to vacillate back near the $535 level there will likely be an opportunity to close this position before expiration for a smaller gain. This scenario increases the overall probability of success with this trade.

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