Tuesday, September 26, 2017 -- At the open of trading of on Monday, September 25, Apple fell to a 30-RSI on the daily chart (at $149.40). This opened up a significant opportunity for investors looking to capitalize on the recent volatility in Apple's stock price. Apple is now down roughly 9.7% from its highs due in part to the "sell-the-news" bear raid that has plagued the stock since Apple introduced its 10-year anniversary iPhone X a few weeks ago.
Those who have been patiently waiting for the right opportunity to jump into Apple's stock may have just been given their chance to do so. Apple only ever enters oversold territory on very rare occasion. What's more, every time Apple has become oversold, it has resulted in a significant buying opportunity when executed together with an apropriate hedge.
Over the past 11 years, Apple's stock has become technically oversold on only 20 total occasions. That is less than once every 6-months for Apple going back to March 2006. The table below shows how Apple has traded immediately after reaching a 30-RSI on the daily chart.
When determining what is the most appropriate way to capitalize on an oversold Apple, it is important to keep in mind that this is a historical analysis of an ongoing trend. There is no guarantee that Apple will continue to follow this trend despite the fact that it goes back 11-years. There is always some level of risk that the next oversold trade doesn't follow the 11-year historical trend.
This is why a trade based on oversold analysis can never be done in a vacuum and always must be hedged. There has to be a strong fundamental basis supporting the trade otherwise the analysis is meaningless. For example, suppose Apple were going bankrupt or suppose iPhone sales were in rapid decline as a result of a mass exodus to Samsung Galaxy phones like we saw with Research-in-Motion a few years back; no amount of oversold analysis is going to help the situation.
The 30-RSI Table Analysis
That being said, there are a number of different conclusions that can be drawn from an analysis of this table above, and each contribute to the overall structure of the trade set-up.
1. The first thing one should immediately notice is that in ALL 20-cases, Apple either immediately crashes or immediately rallies by double-digit percentages upon reaching a 30-RSI. There is no in-between. There is no sideways action and there is no small drop or small rise. The action is dramatic and immediate. This means the trade must be bi-directional similar to an options strangle.
2. The second thing that should be noticed is that the ultimate direction is always up. That while Apple may immediately either rise sharply or fall sharply after reaching a 30-RSI, the ultimate direction is always an eventual double-digit rally off the lows in every single case. Apple either immediately bottoms upon reaching a 30-RSI and then rallies by double-digit percentages or it falls, bottoms and then rallies by double-digit percentages. This tells you that a strict options strangle isn't the best move. It is better instead to go with a long-biased options strangle. Meaning, it's better to be more heavily weighted to the long side with a hedge to the downside than it is to be in a strict 50-50 long-short options strangle.
3. Apple bottoms the very day it hits a 30-RSI in 10 out of the 20 cases or exactly half the time. Now interestingly enough, in 9 out of those 10 cases where Apple bottomed within 1-day of hitting a 30-RSI, it happened during a bull market. This means that Apple has bottomed within 1-day of hitting a 30-RSI 90% of the cases when the stock was in a bull run going back to 2006. Apple has gone through four total bull markets since 2005. There was the 2005-2008 bull run that ended on January 2, 2008. Then there was the March 2009 to September 2012 bull market which ended when Apple began a 45% decline in September 2012. Then there was the July 2013 to July 2015 bull market that ended when Apple began its 35% decline. Finally, we're currently in the fourth bull market which began on Brexit. Apple hit a 30-RSI twice in the 2005-2008 bull market and bottomed within 1-day both times. Apple hit a 30-RSI three times in the 2009 - 2012 bull run and bottomed within 1-day in all three instances. Apple hit a 30-RSI two times in the 2013-2015 bull run and bottomed within 1-day of hitting a 30-RSI in both instances. Finally, Apple has hit a 30-RSI on three instances in this current bull run and bottomed within 1-day twice out of the three previous instances. We are now currently on the fourth occasion as of September 25, 2017. Thus, the takeaway here is that in 90% of the cases (9 out of 10), Apple has bottomed within 1-day of hitting 30-RSI during bull markets. Bull markets must be analyzed differently than bear markets. This is obvious.
4. In all but four occasions (16/20), Apple has completed a 12.5%+ rally on average over a 2-5 weeks time-frame. That's a very short time period in which to complete a double-digit rally. This tells you that waiting for Apple to become "more" oversold is not advisable. In half the cases, Apple immediately bottoms upon reaching a 30-RSI. This is why the most appropriate time in which to enter a trade would be the day Apple hits a 30-RSI or close to it. In a number of cases, Apple has bottomed out just north of 30. In order to have capitalized on all previous twenty oversold trade opportunities, one would have had to enter right at or slightly above a 30-RSI.
5. In 17 out of the 20 past events or roughly 85% of the time, Apple will bottom out within 1-12 trading sessions after reaching a 30-RSI. This is important because it helps give you a general sense of which expiration to use as an options hedge. The further out the options expire, the greater the premium paid. It is important for optimizing the overall trade that one doesn't choose an expiration that is too far out otherwise most of the insurance money is going to premium rather than coverage. If we know that in 85% of the cases, Apple bottoms out in 1-12 trading days after reaching a 30-RSI, then we have a better sense of how far out we want to go.
At the same time, we also want to consider hedging black swan events if we can do so without having to spend too much on insurance. And in this case, that is exactly what we could here. In September 2008, for example, Apple fell for an additional 24-trading sessions after reaching a 30-RSI. It fell 43.96% over the next 24-days which made up the heart of the financial crisis. So we know that by picking an options expirations for the hedge that is at least 5-weeks out, we cover a situation like the financial crisis. The longest period Apple has ever taken to bottom after reaching a 30-RSI, however, was 34-sesions (7-weeks) in December 2015. There the stock fell an additional 13.88% between December 18, 2015 and February 15, 2016.
The Trade Set-Up
So taking these five key factors above along with several other considerations from the table, this is the trade set-up we (Bullish Cross) executed on Monday, September 25. First, right at the open of trading, we decided to buy the Apple January 19, 2018 $160-$170 Call-Spread at $2.15 when Apple was trading near $149.50. Apple got down to around a 30.5-RSI at those prices, became extremely oversold on the hourly and became extremely oversold on the 1-minute chart. Thus it made the most sense to layer into the trade by purchasing the call-spread before putting on the hedge as a $2.00 bounce was likely to come in very short order.
We waited about 30 minutes to hedge the position because we felt Apple would see a very strong intraday bounce after being stretched on ultra near-term indicators which would give us the opportunity to buy our puts at a discount. After Apple bounced $2.00 to $151.70, we stepped in and bought the October 27, 2017 $150 puts at $3.30 a contract (they bottomed at $3.00).
1. Pick Calls/Spread Expiring in 3-4 Months
Now here is why we choose the position we did based on the analysis above. First, we choose to buy the Apple January options because when you look at the last column entitled, "Rally Duration," you can see that it has taken as long as 55-days to complete one of these Apple rallies. While the typical rally lasts roughly 5-weeks, there were at least four out of the twenty cases (20%) where the rally lasted between 7 and 11 weeks. January 19 is 17-weeks from now. This gives us plenty of time in the event of some outlier event.
2. Assume a 10-12% rally will take place
Next we consider the price point we choose. We decided to buy the $160-$170 call-spread specifically because a 12.5% rally from $149.50 is $168.18. If Apple follows the typical historical rally it tends to experience upon reaching oversold conditions, it will rise to $168.18 which is within spitting distance of the high end of the spread. What's more, at $2.15 a contract, the spread would triple in value if Apple rose to $168 a share.
3. Target 200% returns to cover the cost of hedging
Now as to why we choose to buy a spread rather than open calls, that one is simple. You get more leverage with a spread than you do with open calls. If Apple rallies to $168, that spread at $2.15 a contract rises to $7-$8 giving us a much greater return. But if we simply bought the $160 calls at $4.60, our return would be much lower at around 150%. So a call-spread just made the most sense here.
4. Assume Apple can continue to fall for 4-5 weeks after reaching a 30-RSI AND Hedge Accordingly
This brings us to the hedge. As we mentioned above, we bought the October 27, 2017 $150 Apple puts at $3.30 a contract. We picked October 27 because that expiration is exactly 5-weeks away. As we mentioned in our analysis above, historically speaking, the worst post-30-RSI sell-off we've ever seen in Apple's history happened in the financial crisis over a mere 24-trading days.
There was only one instance where Apple fell for a longer duration -- 34-days in December 2015 -- but the bulk of those losses occurred immediately. In fact, most of that 34-day period was sideways trading. Five weeks of those 34-days occurred after Apple had bottomed out. It was merely five weeks between the time Apple bottomed out and when it began a 22.55% rally. So we feel fairly confident that the time-period chosen will adequately cover the position and the amount of premium spent was minimal compared to the coverage received.
5. The hedge should triple in value if Apple falls 6-7% beyond a 30-RSI
Now as to why we choose the $150 puts, that is simple. We conducted a meta analysis of each case and found that the $150 puts offered the most protection under most circumstances while offering optimal protection in the worst circumstances. By purchasing the $150 October 27 puts at $3.33, we know that the position would triple in value if Apple fell to $140 a share or 6.6%. Notice that in 7 out of the 20 cases, Apple fell for more than 6.6% after reaching a 30-RSI over the next 2-weeks on average. The October 27 puts -- being 5-weeks out -- would either triple, quadruple or quintuple in value if Apple fell 6-12% in the next 2-3 weeks.
6. The Hedge should represent 20% of the total capital allocation to the trade
What's more, this analysis showed that the best call-put ratio for the trade to work out in virtually any of the past 20 scenarios would be an 80% long via calls/spreads and 20% short via puts. In our case, we invested $80,000 in the Apple January $160-$170 call-spread and $20,000 in the October 27, 2017 $150 Apple puts in our model portfolio. Consider factor #5 above. If the puts triple in value in a 7% drop in the stock price, at a 20% allocation you make 40%. That will typically off-set losses incurred to the long position.
Let's consider the typical circumstance to demonstrate why this is optimal. Suppose rather than bottoming out at $150, investors continue to sell Apple all the way down to $140 a share over the next 11-trading days or 6.6%. This would be with the range of expectations given the analysis of the 30-RSI table. If Apple fell to $140 a share, the October 27, 2017 $150 puts would rise to $10.00 a contract; or in our case be valued at roughly $60,000 (tripling in value). The January $160-$170 call-spread which would have nearly four months until expiration would fall 50% down to around $1.00 a contract or be valued at $40,000 in our case. By our spread dropping in half and the puts tripling in value, we break-even on the trade.
This would allow us to sell the entire position at break-even, and then re-initiate a new hedged trade with Apple down 12-days beyond the 30-RSI. Meaning, the trade is even stronger now than it was when we first entered in, and it is as if we never put on the trade in the first place. It allows us to step in, put on another similar hedged trade but with Apple trading near a 20-RSI. What you will find in the 30-RSI table above highlighted in green is that Apple has seen 7 prior occasions where the stock bottomed closer to a 20-RSI. In all 7-cases Apple went on to rally more than 20% and sometimes 30%+. Meaning, the trade becomes much stronger if Apple does fall an additional 6-7% beyond a 30-RSI. And by making sure the trade is at break-even, it allows us to put on a whole new trade at a 20-RSI. At the same time, by putting on the trade at a 30-RSI, it allows us to capitalize in the event that Apple decides to bottom within that 1-day of reaching a 30-RSI.
This is the essence of the 30-RSI trade set-up. If Apple bottoms at a 30-RSI, and rallies, you're long and able to capitalize on the trade. If Apple falls to a 20-RSI instead, you're able to break-even by properly hedging, selling the entire position and then re-entering into a new trade with a new hedge. If Apple falls further, your new hedge will allow you to do the same at $10.00 lower so on and so forth until Apple eventually bottoms out and then goes on a monster rally thereby allowing you to capitalize.
Now let's consider how this hedge covers you even in a financial crisis type situation where Apple falls 44%+ in 5-weeks time like we saw in September 2008. If something like that happened, we would be deeply in the positive. If Apple fell to $84 a share over the next 5-weeks as we saw in the financial-crisis, the October $150 puts would skyrocket to $66.00 or $400,000 resulting in an overall return of 300% on the trade. This would be under the assumption that the Apple Jan $160-$170 call-spread went to $0.00. And notice that the hedge only comprised of 20% of the overall trade. We were 80% long and 20% short in this scenario and that 20% short resulted in an overall total return of 300% for the entire trade. We invested $100,000 and sold the entire position at $400,000. This is why the hedge is so important. Without a hedge, it's a total loss. With the hedge, you get a 300% return.
At the same time, if Apple rises to $170 a share and closes at that level at expiration, the total return for the trade is $381,000 or 281%. However, if the position is merely sold at $170 but before expiration, the spread could be exited at around $7.80 to $8.00 or at roughly $300,000 for a 200% return. The point here is that if Apple follows the same historical path that it has tended to follow in bull markets, chances are Apple will immediately rise to around $168 a share. Now being $2.00 below $170, Apple would likely just test the $170 level if not surpass that level momentarily before peaking. Apple isn't going to come that close to $170 and then turn around. That's where the exit opportunity lies on this trade. Notice that even an 11% rise in this trade puts Apple at $166 a share -- and an 11% rally is the smallest we've seen out of Apple on record.
So the general takeaway from this analysis is that when putting on a 30-RSI Apple options trade, the first thing the investors want to do is make sure the trade is fully hedged. What the analysis tells us is that there is a very high probability that Apple will either (1) immediately rally by double-digit percentages or (2) immediately crash followed by an immediate double-digit percentage rally. This means that the only appropriate way to capitalize on the oversold bounce is to put on a hedged trade.
As we demonstrated above, an 80-20 ratio between calls and puts makes the most sense. If you're going to buy $800 worth of calls, it should be hedged with $200 worth of puts. The most suitable expiration based on the historical analysis is roughly 5-weeks out. You don't want to go too far out because then you end up paying too much premium. If you pay too much premium, you won't get the appropriate coverage. A good rule of thumb is to play out different scenarios. If Apple falls 10% in three weeks, will your hedge cover your position? Running different hypotheticals can help determine whether the hedge is appropriate.
The greatest risk to the trade is that Apple just trades sideways from here. What if Apple neither drop nor rallies and just hangs around $150 for several week. That has never happened before, but it could. Just because we have 20 prior cases that suggest the move is going to be up or down sharply from here, doesn't mean that it has to play out that way. This is why this analysis should only be taken together with a good fundamental analysis of the stock. There should be a fundamental reason for Apple to rally in order to make the most of this analysis.
The other risk is the exit. Suppose Apple begins to rally immediately from here and rallies all the way up to $160 a share. That would amount to a 6.7% rally. That isn't quite the 11% rally we've seen historically at the lowest end. But who is to say that Apple doesn't peak at 6.7% this time making a new low end of the range on the table? Understanding where and how to exit is also key. This analysis merely demonstrates how to enter the trade. It doesn't demonstrate how one is to exit. As the trade unfolds, different considerations have to be taken into account in determining what is the appropriate exit. Suppose Apple rises to $165. There is a huge difference in gains between exiting at $165 and exiting at expiration at $170. Again, that comes down to experience and making the right judgment call.