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How to Play Apple Inc. and VMware as We Enter Earnings Season

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Here, some ideas and rationale for potential plays on these popular names.

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Given this week we enter the bulk of earnings season, I will stay away from macro and credit commentary, and instead offer up some ideas and rationale for potential plays on some popular names. Today, the final installment of my earnings option plays covers Apple (NASDAQ:AAPL) and VMware (NYSE:VMW). Note that on Monday I discussed Schlumberger (NYSE:SLB) and IBM (NYSE:IBM) and yesterday I wrote about Google (NASDAQ:GOOG) and Chipotle Mexican Grill (NYSE:CMG).

The approach described below can be translated to all sorts of other names of course, but these are some that technically and/or fundamentally "speak" to me at this point.

Apple Inc.

Apple reports on July 23 after the close. There's little I can offer on the fundamental side that is not well-known, and from a chart standpoint, there isn't much that can tell us what's going to happen next. In fact, it's only in hindsight that we will find out if the April and June lows were a "double bottom," or why the price seems stuck in between the 8-, 21-, and 50-day moving averages. In DeMark terms, a drop toward the lows would give it a chance to complete the active Combo Buy signal, but on the flip side, if the current daily TD Sell Setup completes, it would invalidate the Combo Buy count and possibly signal a change of trend. Have I lost you? I hope so. My antennas go up when I hear people comment that the "fundamentals are unclear, but the chart says it all," or that "the fundamentals/valuation are no-brainers, even if the chart is a mess." The fact is that price patterns incorporate a lot of the certainty or uncertainty around a company's business. And in this case both the chart and fundamental analysis are consistent in their message: AAPL stock is full of unknowns.

However, the two constants we can count on are AAPL's massive buyback/dividend, and the fact that stock's underperformance is not good for executive compensation and job safety. So I will stick my neck out and submit to you that it is very unlikely Tim Cook & Co. will allow the stock to drop much below the recent lows before its $50 billion cash hoard puts an immovable bid under the stock. That's the presumption I am working on to play the name going into earnings.

AAPL's average 1-day post-earnings move going back more than 10 years is 5.3% or about $23. That's almost exactly the price move suggested by current option pricing. The 30- and 60-day normalized implied volatility, i.e. implied volatility during periods without major catalysts, is about 27%, and the August 2 options trade at about 33% ivol.

Position: The price objectives to the upside or downside are fairly obvious: the $460-470 neckline of the potential "double bottom" breakout, and support at the recent $380 lows. The tricky part is to correctly guess the direction. If one is outright bullish, the Aug. 2 1x3x2 uneven butterfly on the 425/465/485 calls can be bought for about $10.50. Assuming a volatility drop of 8% post-earnings, on July 27 the position should break even between $434-482, and should have max gains of about 170% with the stock around $464. Max risk is the premium paid. A similar position on the bearish side can use the 420/380/360 puts for a $5.90 cost, breakeven on July 27 between $418-$351, max gain of about 2.7x at around $385, and max risk of the premium paid. (Please note all these numbers are approximations since I used prices from yesterday while the markets were still open.) Again, these strategies in my opinion make sense only if you have a strong conviction on the direction of the move.

For myself, I am not in the "high conviction" camp as to how the stock will trade after the report. What I am comfortable with is owning the stock around $385. Over the last several weeks I have unsuccessfully put on back-ratio put spreads (these consist of buying a put at a given strike, and selling a higher number of puts at a lower strike) only to have them always expire worthless, usually for break-even money. I am leaning toward trying this again with the Aug. 2 415/400 puts on a 1x2 ratio, for about a $0.35 debit. This will effectively make me short the stock between $414.65 and $385.35, and long below that.

VMware

VMW reports on July 23 after the market close. To my eyes, this is a much simpler setup. Both traditional chart patterns as well as DeMark counts are on a weak-neutral to outright bearish posture, and fundamentally/valuation-wise the stock is expensive and its business is not exactly humming. However, I do think that at the right price VMW is a tremendous long-term, best-in-class opportunity. My "wish for" price is around $50, but I'd be OK buying a small piece in the mid to high $50s which is where there's a fair amount of technical support, and where, on an EV/EBITDA basis, I could stomach the valuation. I have no desire to short the stock, or to take a flyer that it will rip post earnings; it might rip, but I'd see that as driven by "the greater fool theory" more than anything else.

The average 1-day move post earnings going back to VMW's IPO is 7.2% or about $5 based on the current price of $72. VMW does not have weekly options available (though I believe some may roll out at the open on Thursday) so I'm working off of August expiration. The 30- and 60-day normalized implied volatility, i.e. implied volatility during periods without major catalysts, is about 39% and the August implied vols area about 43% (in absolute terms, both implied volatilities are pretty high).

Position: As mentioned above, my only goal here is to get long the stock at a decent price. My inclination is once again to use back-ratio put spreads, specifically the August 67.50/62.50 1x2 for about $0.50 debit, or the 65/60 1x3 at even-money. Of course the strike prices and ratios can be tuned to anyone's taste and risk appetite; the concept remains the same. Also, if the July 26 weeklies are rolled out this Thursday, they are likely to sport much higher implied volatilities, which for ratio spreads can make the entry price much more advantageous.

That sums up my approach to trading (or not) Schlumberger and IBM, Google and Chipotle Mexican Grill, and Apple and VMware. Besides my views on these specific names, hopefully you've gotten a sense of how you can structure options to a) define risk, and b) have a chance to take positions in a stock at a specific price even if the stock never actually trades at that level.

Happy Trading!

Twitter: @FZucchi
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Positions in AAPL, IBM.
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