How to think about options?

[compoundinglife]

Moving this discussion over from the AAPL thread.

 

What do you guys think about the LEAPs?

 

Apple right now looks insanely cheap if you back out the cash.  The P/E ratio is insane and Apple's growth is insane (very very few small caps have grown faster).  The LEAPs are reasonably priced and look like a safer way to play this.  Usually technology companies grow really quickly or die really quickly.  This should mean that the options should be a little more expensive than what historical volatility might suggest.  (Or I could be wrong.)

 

Interesting.  I had the opposite thought -- that LEAPS would be a little dangerous. 

 

I suppose that's because I've modeled very, very conservatively, with ASP and GM decline every year, pretty good slow down in unit growth for iPad and iPhone, declining Mac unit sales, modest software/services growth, and giving no value to potential new products such as a watch or TV.  And then taking a haircut on the cash position, of course, both for taxes and possible acquisitions/partnerships that will be necessary for a transition to more software/services revenue.

 

That puts me at a declining EPS, which is something the market won't like one bit.  Granted, I'm being pretty conservative, but this is a tech company after all. 

 

Just a thought on whether to go with LEAPS versus common.

 

The way I am thinking about it is 100 shares of AAPL costs your $39,000 today. A 2015 $400 LEAP costs you $5600. Instead of buying of the common, buy the LEAP and take the remaining $33,400 and put it in a compounding machine that you want to hold. Let's say you put that $33,400 in FFH. In the case that your LEAP goes to zero and FFH is able to compound over time at %15 per anum the first %15 almost covers your cost of the LEAP.

 

Value Line estimates 44.50 for 2013 and 52 for 2014 earnings, a PE of 12 on 44.50 is 534. Let's call it $500. So if at expiration (Jan. 15) AAPL is $500 and you at some point get your %15 growth per anum on FFH you wind up  $48,410 vs 100 AAPL common at 500 which would be $50,000.

 

Of course the simplest explanation is you invest $5600 and if AAPL is below $456 at expiration you lose it all.

 

But for whatever reason in the context of buying the common vs spending the same $$ and buying the LEAP plus FFH the second seems like a better option to me. Maybe I am just over thinking it.

 

Umm... I think options are a little complicated and difficult to grasp.

 

I would try to understand the basics of options first.  e.g. put-call parity

Then try to understand the Black-Scholes model.  This is a little unintuitive at first, but the direction of the stock mostly doesn't matter if delta hedging works.

Then try to understand areas where the Black-Scholes model should be modified.

Then you will understand why many options traders use BS by fudging the volatility parameter in it.  Pricing options is an art, not an exact science.

 

Taleb's book was helpful for me.

 

Or maybe take a step back and look at it like this.

 

The options market is a zero-sum game.

Suppose for a second that there were no transaction costs.  And suppose that taxes don't matter.

In a frictionless world... then there would be some "correct" price for every option.

 

If the call (or put) option is too cheap, then I would have to say that it's less risky than the common.  A put option is like insurance.  (And because of put-call parity, you can usually turn calls into puts and vice versa.)  If you get paid to own insurance, then that's awesome and not very risky.  If the put/call options are too cheap, then it's like you are getting paid to own insurance.

 

2- The options markets give you access to a lot of leverage.  Increasing leverage increases your risk.

 

BUT, you don't have to increase your leverage.  You can buy 1 option contract instead of 100 shares.

 

3- In practice:

a- There are transaction costs, sometimes the options market is slightly stacked against investors, there are taxes, etc.

b- Options are complicated.

c- It's really hard to value options.  (So, you know... look for a margin of safety.  Otherwise, nobody is forcing you to swing at any pitch.)

[GrizzlyRock]

If Apple realizes that allocating their massive FCF to repurchases (as opposed to increasing the dividend) the Apple LEAPS could be very interesting

[compoundinglife]

ValueTrap,

 

I think I get what you are saying which is basically that trading options is trading volatility. In a world of no transaction costs where you think the future volatility is going be greater than the implied volatility you can delta hedge and capture a gain a regardless of the markets direction.

 

But does that mean that viewing a long a call as a proxy for being long the stock is a flawed view? I don't think it is but I think that is your message. I am misunderstanding you?

[no_free_lunch]

I normally am not a big fan of options but they seem more appropriate for apple.  The stock is at a crossroads, it is unclear if earnings will be maintained, we don't know what future products they will release and if they will be successful.  We do know that the market thinks earnings are in for a slow decline.  If they are wrong the stock will have to move up and sharply.  With the 2015 options you have a reasonable amount of time.

 

Compounding life, you use very conservative estimates to come up with $500.  It makes sense to be conservative, but I would also look at the more aggressive side of conservative.  If they can do $56 earnings and the market thinks that is maintainable you could easily see $700 again.  Not something to bank on but it gives reasonable upper and lower bounds if the roof doesn't collapse.

 

When you look at it like that you are looking at 2X-6X your investment if things work out, say 0x if they don't.  Sounds like good odds to me.  If you are being conservative and only putting a fraction of your portfolio at risk, especially if you were going with hedged FFH, that sounds like an interesting strategy to me.

[compoundinglife]

I normally am not a big fan of options but they seem more appropriate for apple.  The stock is at a crossroads, it is unclear if earnings will be maintained, we don't know what future products they will release and if they will be successful.  We do know that the market thinks earnings are in for a slow decline.  If they are wrong the stock will have to move up and sharply.  With the 2015 options you have a reasonable amount of time.

 

Agreed. Part of the reason why I like the options in this case is because I feel that if by 2015 the stock has not appreciated or has depreciated further it is *likely*  because I was wrong about Apple and there is some big deterioration in their business in which case if I was holding the common I would probably not want hold it any more anyways. As apposed to say a BRK or FFH where I would keep holding regardless of price and price is probably not indicative of any long term fundamental problems.

 

Compounding life, you use very conservative estimates to come up with $500.  It makes sense to be conservative, but I would also look at the more aggressive side of conservative.  If they can do $56 earnings and the market thinks that is maintainable you could easily see $700 again.  Not something to bank on but it gives reasonable upper and lower bounds if the roof doesn't collapse.

 

When you look at it like that you are looking at 2X-6X your investment if things work out, say 0x if they don't.  Sounds like good odds to me.  If you are being conservative and only putting a fraction of your portfolio at risk, especially if you were going with hedged FFH, that sounds like an interesting strategy to me.

 

Yeah when I looked at I did take into account much more optimistic outcomes :) I just chose to post something conservative in the example.

[Packer16]

One question I have always had about Apple and other widely held stocks is what do I know that others do not.  It may appear cheap but given the number of folks following this stock, I think there is a reason why it is trading where it is versus say some smaller less known names.  If had a moat like Coke then it would clearly be a bargain but the question is how long can they maintain their competitive advantage (esp. with other mee-too device flooding the market).

 

Packer 

[compoundinglife]

One question I have always had about Apple and other widely held stocks is what do I know that others do not.  It may appear cheap but given the number of folks following this stock, I think there is a reason why it is trading where it is versus say some smaller less known names.  If had a moat like Coke then it would clearly be a bargain but the question is how long can they maintain their competitive advantage (esp. with other mee-too device flooding the market).

 

Packer

 

That is a good question and definitely something that needs to be considered. Going to attempt to flip the question around a bit. When you have a stock that is very widely held, a ex-darling of retail investors and mutual funds whose to say that they are selling because they know something you don't. Or maybe they know what we know which is that there are probably some road bumps in the near future and they don't want to go along for that part of the ride.

 

[Packer16]

You have a good point but the competition for a stock like apple is alot different than for a smaller firm like OSTK, AIQ or TVL.  Investing is like a competitive sport with the competition for well known like AAPL being like playing a professional tennis player and investing in less well known names playing against your middle aged a little overweight neighbor.  That is why I am always skeptical of getting a good bargain with large cap stocks.  Look a Longleaf as an example.  They for the most part invest in large caps using a concentrated value approach but have failed to beat the S&P?  Why?  Not because they are poor value investors but because with large caps you have keen competition.  In AAPL's case what has happened to every large cap tech company that has reached AAPL's market cap?  I can think of IBM and MSFT.  They have stagnated or declined.  Again due to keen competition and the IBM and MSFT not being able to grow.  Based upon my understanding, AAPL's model is not as robust as either IBM's or MSFT's, so why would they be able to have different results.  Another aspect that is more technical who else is there to buy AAPL?  Just some thoughts.

 

Packer     

[ItsAValueTrap]

But does that mean that viewing a long a call as a proxy for being long the stock is a flawed view? I don't think it is but I think that is your message. I am misunderstanding you?

 

Here's how I look at it.  You can bet on the underlying stock and throw an additional bet on volatility on top of that.

 

#1- If I like the stock, I might look at the options too since they might be even better than the common stock.

 

#2- Determine whether the options are overpriced or underpriced, regardless of the direction of the stock.  Is volatility over or underpriced?

 

#3- Let's say the options are fairly priced or underpriced.

Buy the options and don't hedge.  Maybe the stock is good but the options are even better.

 

If the options are really overpriced, then maybe you want to sell volatility.  (Buffett did this for BNI.)  Again, don't hedge if you want to bet on the direction of the stock.

 

Maybe I can't figure out if the options are over/underpriced.  (I like obvious stuff.)  There's nothing wrong with avoiding the options altogether and just sticking with the common.

[ItsAValueTrap]

One question I have always had about Apple and other widely held stocks is what do I know that others do not.

 

I think misvaluations can occur with large caps.  Berkshire Hathaway is sometimes mispriced.  The various Malone/Liberty companies have definitely been mispriced often.

 

Many large caps during the tech bubble and 08/09 crash were mispriced.  Anything in the S&P 500 will often fall 50% from its 52wk high.

 

A long time ago, Warren put most of his investment partnership's money into a large cap called American Express.

 

2- Look in the small cap space and try to find a company that grows faster than Apple and trades at a low P/E.  It's really, really hard.

[Packer16]

That is true but for the most part there are either reasons why or they are on sale only during a crisis.  Malone/Liberty - complex structure and AmExp the salad oil scandal.  As to AAPL's growth I do not think it is sustainable given the lack of locked in recurring revenue in many of their revenue streams (iphone and ipad for example).  How many of these devices do folks need and as the competitors catch-up with functionality they will compete on price and revenue will drop off as competitor take share.  The other issue of growth is that it is harder and harder to grow a large revenue stream. 

 

Packer 

[GrizzlyRock]

First, let me say that I have never owned Apple stock so I'm not a fanboy or a Apple homer...

 

WRT to the "moat" at Apple it is certainly not exceptional like Coke or AmEx but it does exist - think I Tunes ecosystem, synching devices from home, mobile, table etc.

 

The question to ask with Apple currently if you are going to make an argument that its cheap is why its cheap. The best explanation I have is a behavioral explanation. Last summer, non-finance people began asking me if I thought Apple was going to hit $1,000.  That is clearly a ridiculous question.  But that is the situation with Apple - so as the sheen comes off Apple then it's no longer popular to own and the traders have taken over to push it down.  Marginal sellers set price. The market appears to be somewhat irrational in its pricing of Apple currently...  Time will tell.

 

 

Lastly, using options for a leveraged play on a new cash company really can work especially in the case of a cannibal like DTV. Another trade I've never done but I know a bunch of guys who have cleaned up with this trade in DTV

[Packer16]

You are correct but the question how much of the apple demand is from these non-finance folks.  If AAPL was such a great bargain I think some of the larger more sophisticated buyers would bid the price up.  I think AAPL has the same problem as MSFT with a great business (itunes ecosystem) generating alot of cash flow that is being re-invested in not so great or cyclical businesses (phones and consumer electronics).  As another benchmark if you look at the Morningstar FV, AAPL is modestly undervalued. 

 

I feel DTV is better business due to its recurring revenues and better buy due to its buybacks with cheap leverage.

 

Packer

[ItsAValueTrap]

The question to ask with Apple currently if you are going to make an argument that its cheap is why its cheap.

I'm gonna be cheeky here and say that their earnings have grown faster than the share price.  :P  Revenue has grown 37%/yr over the past 10 years, FCF and EBITDA and book value have grown even faster than that.  This is without using debt.

 

On the other hand, I sold my Apple shares because I think that Android will likely win the smartphone and tablet wars.  It's hard to figure out.

[twacowfca]

First, let me say that I have never owned Apple stock so I'm not a fanboy or a Apple homer...

 

WRT to the "moat" at Apple it is certainly not exceptional like Coke or AmEx but it does exist - think I Tunes ecosystem, synching devices from home, mobile, table etc.

 

The question to ask with Apple currently if you are going to make an argument that its cheap is why its cheap. The best explanation I have is a behavioral explanation. Last summer, non-finance people began asking me if I thought Apple was going to hit $1,000.  That is clearly a ridiculous question.  But that is the situation with Apple - so as the sheen comes off Apple then it's no longer popular to own and the traders have taken over to push it down.  Marginal sellers set price. The market appears to be somewhat irrational in its pricing of Apple currently...  Time will tell.

 

 

Lastly, using options for a leveraged play on a new cash company really can work especially in the case of a cannibal like DTV. Another trade I've never done but I know a bunch of guys who have cleaned up with this trade in DTV

 

Please explain the DTV trade.  Thank you.

 

PS  It's not necessary for many on this thread to create stories about why Apple has declined.  It has declined because it was virtually impossible for it to advance beyond the near universal 5% limit imposed funds.  When Apple approached 5% of the total market cap of the S&P500, it hit the limit.  :)

[LC]

Probably simply call options of DTV...Malone is pretty much issuing debt to buyback shares. Which makes sense given the lower capex of Satellite versus Cable providers. And of course the "low interest rate environment"  The question is how much more debt he wants to saddle the horse with.

[Packer16]

From what I have read his goal is 2.5x EBITDA which would be an addition $7 to $8 billion or 2 more years at the stated rate of $4 billion per year.

 

PAcker

 

[compoundinglife]

From what I have read his goal is 2.5x EBITDA which would be an addition $7 to $8 billion or 2 more years at the stated rate of $4 billion per year.

 

PAcker

 

Value Line has estimated share counts of 2013: 528M, 2014: 500M, 2016-2018: 475M.  It says there were 586M outstanding for 2012. Seems to jive with what you are saying since the # of shares reduced will go down as the price per share goes up.

[no_free_lunch]

How many of these devices do folks need and as the competitors catch-up with functionality they will compete on price and revenue will drop off as competitor take share.

 

I too am not an apple fanboy and I don't want to say that Apple will necessarily maintain their revenue and earnings, it's very hard to say.  I would say that there are historical precedents with apple for maintaining their revenue in different segments.  Mac prices are significantly higher than comparable windows based PCs and they continue to sell well.  I would say there is generally a 50% price premium if not more.  There is also a precedent with the IPOD where they continue to charge premium pricing a decade after the product was released and despite numerous competitors in the market.  Will the same happen with Iphone / Ipad sales, too hard to call but certainly possible.

[LC]

This is why I took a small position: 

 

Apple has a history of surviving. Somehow, the Apple Mac was able to survive the onslaught of Windows. In fact, recently the Apple brand has become so powerful that a comparable Windows PC can cost 25% of the price of a premium Mac. Windows may be the best selling OS of all time, but Apple can price their hardware to the stratosphere. Now Android may win the mobile OS space, I don't know. But I'm thinking Apple will still be able to price it's I-Whatever's above the commodity handsets everyone else releases.

 

When I think of the other mobile handset producers, I have no brand identity of a single one besides Apple. 

 

What is Samsung known for? What is Nokia known for? What is Blackberry known for? (ok, maybe blackberry: they are the only guys left with a keyboard). What is Motorola known for?

 

But I know Apple is high quality.

 

I'm sure these are old arguments that have been mentioned in the Apple thread countless times, but I figure with the Price:Cash ratio of the shares, the history that Apple has battling in the computing space, and their brand name, it's worth a small bet.

[plato1976]

The question is really, if they can maintain a high margin (not as high as now, but still higher than other competitors, for which the answer I think is yes), and maintain their current revenue stream.

I would like to think they will face pressure to the keep the market share - but somehow the pie is still growing.

The bad news is that the major growth for mobile devices will be mainly from EM market and low tier - it's not exactly good news for apple.

I still think there will be lots of innovation ahead about human-computer interfaces - but there is no certainty that Apple will grab/dominate the next hotspot

 

all after all, I decide to establish a small position on Monday, just before the ER

 

How many of these devices do folks need and as the competitors catch-up with functionality they will compete on price and revenue will drop off as competitor take share.

 

I too am not an apple fanboy and I don't want to say that Apple will necessarily maintain their revenue and earnings, it's very hard to say.  I would say that there are historical precedents with apple for maintaining their revenue in different segments.  Mac prices are significantly higher than comparable windows based PCs and they continue to sell well.  I would say there is generally a 50% price premium if not more.  There is also a precedent with the IPOD where they continue to charge premium pricing a decade after the product was released and despite numerous competitors in the market.  Will the same happen with Iphone / Ipad sales, too hard to call but certainly possible.

[Uccmal]

You guys are debating the stock/company again, not discussing using options.

 

I have some experience with options and have thought a bit about the Apple situation in this regard.

 

Some thoughts and experiences:

 

Successes:

a)FFH leaps - We, collective we (this message board) knew the issues with FFH as much as anyone.  We knew that the issues were getting behind them when we first initiated Leap positions.  The Leaps were a way to lever the return to value.  It was not based on FFh actually growing but surviving.

b) AMEX, SB, GE, WFC - all Longest Leaps - As above - a survival story or return to value.  If these turned against me I would have had my house, a little cash, a job, in a severe depression.

c) BAC, WFC, JPM, AIG - return to value in all cases.  Proxy for common to add leverage

 

Failures:

1) Trying to duplicate FFh success with smaller companies - I have done it enough times to know to stay away.

2) Rim - Buying Leaps, Selling puts - I got hammered.  In this case I would call it fighting the tape. 

3) Buying puts in general.  This never seems to work very well.  I still use them, strictly as insurance, accepting ahead of time that I will probably lose, but they serve a purpose.

4) Selling puts.  There are better ways to earn income - buy WFC, or SSW instead.  Unless you really want the stock at the lower price.

5) Buy and hold, either on purpose, or through forced holding (liquidity dries up).  example: MFC options.  Options are for trading.  The only time I have ever exercised them is with FFH.

 

So what can I learn from all this. 

1)Return to value situations work best

2) If an option hasn't moved into the money when the next Leap cycle ensues I get rid of it completely.  For US investors, this will mean waiting your one day plus a year to get your tax loss.  Revisit your situation and buy more leaps or take your losses and stay away. 

3) Lock in my gains as soon as The next cycle comes out, subject to tax issues.  Basically, get rid of buy and hold mentality.  Buy more at the time limit Leaps if upside still exisits on stock. 

4) Dont sell puts unless I want the stock at a new improved price.

5) Only buy puts as insurance, not to make money.

 

To the Apple situation directly:

 

Ask yourself how many times in history you have seen a high flyer regain its value quick enough to make money on your Leaps?  If Apple reports weaker than expected earnings, meets expectations, or even slightly exceeds them the stock will stay down.  What is the chance something will materialize to take it back up to $500.  To get to $500 in 1.6 years you need something big.  Will this happen in that time period?  Are you willing to eat %100 on your position?  If these are all acceptable to you then by all means go ahead.  Otherwise stay with the common, or in my case none at all.  I am not willing to fight the tape, Yet!

 

[GrizzlyRock]

WRT to my comments regarding DirectTV the thesis is as follows:

 

Black-Scholes option pricing is based on 5 factors: current price of underlying, strike price of underlying, time, risk free interest rate, and implied volatility. Of these - 4 factors are knows so the guys that price options rely on guessing what the implied vol of the underlying will be in pricing the option.

 

My point is that massive share repurchases dramatically increase per share value on a level that is wholly unaccounted for by route option pricing and especially stabbing at implied vol for multiple years.

 

In DTV's cash massive share repurchases is an understatement: "As of December 31, 2012, we have repurchased approximately $25.7 billion of our common stock over the last seven years, retiring approximately 60% of our then-outstanding shares, and have announced a new $4 billion share repurchase program."

 

So LEAP options on the cannibals is a highly interesting strategy as option pricing simply doesn't account for dilution / share repurchases.

[twacowfca]

You guys are debating the stock/company again, not discussing using options.

 

I have some experience with options and have thought a bit about the Apple situation in this regard.

 

Some thoughts and experiences:

 

Successes:

a)FFH leaps - We, collective we (this message board) knew the issues with FFH as much as anyone.  We knew that the issues were getting behind them when we first initiated Leap positions.  The Leaps were a way to lever the return to value.  It was not based on FFh actually growing but surviving.

b) AMEX, SB, GE, WFC - all Longest Leaps - As above - a survival story or return to value.  If these turned against me I would have had my house, a little cash, a job, in a severe depression.

c) BAC, WFC, JPM, AIG - return to value in all cases.  Proxy for common to add leverage

 

Failures:

1) Trying to duplicate FFh success with smaller companies - I have done it enough times to know to stay away.

2) Rim - Buying Leaps, Selling puts - I got hammered.  In this case I would call it fighting the tape. 

3) Buying puts in general.  This never seems to work very well.  I still use them, strictly as insurance, accepting ahead of time that I will probably lose, but they serve a purpose.

4) Selling puts.  There are better ways to earn income - buy WFC, or SSW instead.  Unless you really want the stock at the lower price.

5) Buy and hold, either on purpose, or through forced holding (liquidity dries up).  example: MFC options.  Options are for trading.  The only time I have ever exercised them is with FFH.

 

So what can I learn from all this. 

1)Return to value situations work best

2) If an option hasn't moved into the money when the next Leap cycle ensues I get rid of it completely.  For US investors, this will mean waiting your one day plus a year to get your tax loss.  Revisit your situation and buy more leaps or take your losses and stay away. 

3) Lock in my gains as soon as The next cycle comes out, subject to tax issues.  Basically, get rid of buy and hold mentality.  Buy more at the time limit Leaps if upside still exisits on stock. 

4) Dont sell puts unless I want the stock at a new improved price.

5) Only buy puts as insurance, not to make money.

 

To the Apple situation directly:

 

Ask yourself how many times in history you have seen a high flyer regain its value quick enough to make money on your Leaps?  If Apple reports weaker than expected earnings, meets expectations, or even slightly exceeds them the stock will stay down.  What is the chance something will materialize to take it back up to $500.  To get to $500 in 1.6 years you need something big.  Will this happen in that time period?  Are you willing to eat %100 on your position?  If these are all acceptable to you then by all means go ahead.  Otherwise stay with the common, or in my case none at all.  I am not willing to fight the tape, Yet!

 

Great perspective.  :)

[stahleyp]

You guys have to remember that Apple has a great history under Jobs. Does anyone know of a time that Apple was a great company without Jobs??? Yes, the stock is pretty cheap and intriguing. Nokia and BBRY were cool at one time too. Remember when BBRY (RIMM) was at $30 and it looked like a steal? There is a reason the market prices these things so cheap sometimes. Things that are cheap can get much cheaper...especially in technology.  However, Jobs had a huge influence of that company. In my view, much, much bigger than virtually any other super large company. When your visionary leader is no longer there...well, I suppose we'll see what happens. We may have already seen round 1 back 25 years or so ago. Apple might turn out to be a great investment, but you have to have a bigger margin of safety than normal because of the industry it's in. With all that being said, I've been wrong about Apple more than I've been right. haha Good luck to the longs.