About seven months ago, I wrote a blog post on an Apple protective-collar position I invested in. It was a defined-outcome type investment where I only took limited risk (less risk than holding long Apple shares). I called it my Apple bet. It was a 27-month long position. So today, seven months have passed. It is time for a quick update on it.
To recall from that post, I had paid about $176 per Apple share in March. I’d also paid $11.65 per share for the downside/upside protection on it—essentially my protective collar. You can see the details in this table from that post.
Today, Apple is trading at around $248 a share. But my upside gain is capped at $225 so I won’t benefit from any further rise of its share price. I have also pocketed two quarterly dividend payments ($0.77 each) so far, with a third one due in two weeks.
As far as dividends go, I am a little disappointed with Apple. Back in March when I set this position up, I had just received $0.73 dividend. From there, I expected Apple to grow its dividend by about 12%. Then in May, Apple raised dividend to $0.77. That amounted to a 5.5% yearly increase—less than what I was expecting. Apple’s financial condition is still excellent with excess cash on the balance sheet and ample free cash flow. I am not sure why it decided to pull back a bit on this year’s dividend raise. It could be that Apple is considering other uses for its cash, like a major acquisition or some new R&D project. Or perhaps, it will be more aggressive with the next year’s dividend raise. I don’t know, but nevertheless my investment still works fine regardless of what Apple chooses to do. So long as it doesn’t cut its dividend payout—a scenario I consider highly unlikely.
So, in just about seven months, this position has gained $49 per share due to Apple’s share price jump. And another $1.54 in dividends received. On $176 per share cost basis, if I close the position today, I’d get 19% annualized return. This is significantly more than what I had originally set out for. If I let it run until maturity—which is still about 20 months away (June 2021)—my annualized return would be 9.8%.
At first glance, it seems obvious that I should close this position today—rather than wait for another 20 months. I would realize maximum capital gain. But I would also lose out on the remaining seven dividend payments. Those would amount to $5.39 (assuming no dividend increase)—about 11% of my $49 capital gain. A bigger expense though would be the cost of buying back the protective collar I had put on Apple shares. Even though my call options are in-the-money (i.e. share price higher than call strike price), there is still considerable residual time-value left in them. I will get some of it back from selling the long put options. Taking all this into account, I’d have to pay $14.65 per share to close this position today. Net gain would then be $24.35. The table below shows the details.
Apple has done well beyond my expectations since the beginning of the year. It has recovered from a low of $142 to today’s high of $248. Back then at its low point, it was trading at an earnings multiple of 13x while today it’s valued at about 20x. Not much has changed in the business—it’s still the same steady solid business as before. I wrote in the March blog post that I like Apple’s business and its management. I still feel the same way, but it appears that the market now likes it too. Apple might not be the first with a 5G phone or a foldable screen, but it still has the same loyal fan base, huge brand recognition, and premium pricing power. At 20x earnings, it’s not a bargain but still at a reasonable price.
What if I wait another six months (or another year) before I close this position? Estimating potential gain for those scenarios requires some understanding of how stock options work. Two key factors that impact Apple call/put valuations are (a) Apple’s share price and (b) time remaining until option expiration. Those two factors are represented by Delta and Theta values in the previous table.
Delta shows what happens to the value of an option for each $1 increase in Apple’s share price. With Deltas of 0.686 and negative 0.133, a one-dollar rise in the Apple share price would increase my call value by 68.6 cents—and decrease put value by 13.3 cents.
Theta shows the effect of time decay. So, every day that goes by, these options lose some time premium—eventually dropping to zero at the expiration date. From the values in the table, my calls decrease by 3.1 cents and puts by 1.5 cents every day.
Note that Delta and Theta are not static numbers. They will change over time and with share price movement. For more on Delta, Theta, and other Option Greeks, see this post: Using the Greeks to understand options.
With these numbers, I can roughly estimate remaining time-value of my collar six months and one year from now. At expiration, all time-values go down to zero. I will skip the rest of the math behind these numbers. The results are shown in below tables. Assuming Apple shares stay unchanged at $248, if I close this position six months or one year from now, or at expiration, my net gain would be $29.14, $33.79, or $44.39 per share respectively. And my effective annualized return would go down from 19.9% today to 13.3% in six months, 10.6% in one year, and 9.8% in June 2021.
All of this assumes that Apple shares stay at the same price (around $248) throughout. This is of course unlikely. If Apple shares rise further from here, I will be able to close this collar early with less cost. If Apple drops, I may have to wait longer to get same net gain. However, as long as Apple shares stay above $225 when the collar expires in 2021, I’d still get my target return of 9.8%.
Another aspect to consider here is whether I have a ready replacement for this position. After all, that 19% early return won’t be nearly as valuable to me if I am unable to reinvest the proceedings into another promising position shortly thereafter.
Most investors understand this point but perhaps it is worth repeating here. If I get a high annualized return for a short period of time but then fail to reinvest at an equally high return for later periods, my overall return goes down. Here’s an example: Say I invested $1000 in a hot stock and gained 20% in just two short months. My return for those two months (when annualized) would be a whopping 299% (CAGR). But this return is only sustainable if I could continue to find opportunities every two months to invest and reap 20% profits. Conversely, if I just sit for the next 10 months and make no additional money, my rate of return would come down to an ordinary 20%. Finding compelling reinvesting opportunities is just as important as harvesting gains on existing investments.
For now, I’ve decided not to pull the plug on this position. In dollar terms, I have already gained about half of my target net return in seven months.
Apple stock’s sharp rise in last six months has been a bit surprising. When I wrote the post in March, I had thought it would likely go above $225 in two years, but I wasn’t expecting it this soon. Given where Apple is today, it’s entirely possible that it will give back some of its recent gains in the coming months. But this position still has long ways to go—four months short of two years. By then, Apple may have 5G capable phones, new wearables, and higher revenue from subscriptions and services. Even if it falters from here, I still place good odds at its recovery before this position runs out of time.
Besides, I don’t have an alternate investment opportunity at this time. I am looking though. 3M stock has taken a beating lately and I am researching it to assess whether it could make a compelling investment. More on it in a future post. Meanwhile, I keep this Apple position, collect dividends on it, and let the time-value of my collar declines gradually.
We investors can’t control what the market does to our stocks every day. But occasionally we can take advantage of irrational price swings. This Apple bet is in the same spirit. Apple is still the same business as it was seven months ago. And yet its shares have gone up by 70% since then. I am a happy rider.