AAPL: splits, calls and puts. Feb 27-2013

Efficent Alpha. 


Shares of Apple (AAPL) jumped after a rumor spread on the Twitterverse about a possible stock split and special dividend. While the short answer is that a split should not matter to a company’s intrinsic value, there is a strong case for an increase in the shares and the options market could allow for more flexibility.

Gnomes and Apple’s shareholder meeting

Hedge fund manager Doug Kass tweeted his position on Apple and that his source was talking about a possible stock split at the Cupertino behemoth. The shares had been lagging the S&P 500, shown in the chart below, by 0.8% until the news. After the news, volume spiked and the shares jumped to beat the market by 1.7% on the day.

Kass’ tweet from his account @DougKass read,

High above the Alps my Gnome is hearing a rumor that Apple will announce a stock split at tomorrow’s shareholder meeting. $AAPL.

(click to enlarge)Apple stock split rumor

While Kass later downplayed the rumor, the idea of a stock split for the triple-digit shares is not a new one. The shares have split three times in their almost three-decade history; in 1987, 2000, and 2005. The February 2005 2-for-1 split; when the shares were trading at $44.86 after the split, saw the price back up to $80 within a year.

Does a split really matter?

The quick response by analysts and academics is that a stock split should not result in an increase in value for the shares. The price-earnings ratio, the favorite measure of a stock’s worth, does not change. While some will argue psychological effects drive a stock’s value higher after a split, this really is not a factor for institutional investors which own 64% of the shares. In fact, a split will actually increase the costs for these institutional investors because they must now buy more shares to invest the same amount of money.

Proponents of a share split often cite a 2010 study of stocks on the Nairobi Stock Exchange (pdf) showing positive average abnormal returns around the split announcement. The study also found a positive market reaction in the form of an increase in volume and trading activity, consistent with the signaling hypothesis. Researchers at Yale in 2004 (pdf) found less evidence of an effect on returns but confirmed a shift in investor clientele as individual investors increase their holdings while institutional investors sell.

My own feeling is that a split will not usually matter over the longer-term for most stocks. Once the media fervor and enthusiasm by retail investors subsides, the valuation for the shares should adjust to their pre-split level.

But there is a good reason this might not be the case for Apple.

At very high prices, there are some significant hurdles for retail investors in shares of Apple. At almost $500 per share, many of the option strategies that I use for risk management are prohibitively expensive. Even without options strategies, putting down a couple of thousand dollars for a few shares of Apple may not be possible for smaller investors and a diversified portfolio.

For example, I am bullish on shares of Apple and believe it to be a good value play. I am not quite as bullish on the general economy and the market’s valuation. Nor am I entirely sure that Apple can fend off competitors like Samsung Electronics (SSNLF.PK) or BlackBerry (BBRY) to maintain its high margins. While BlackBerry has been written off by most of the investing public, the company is reporting increased interest in its new Z10 smartphone and could make a comeback in the States. While Google (GOOG) has recently announced that it has no plans for retail stores, the company is presenting an ever-evolving competitive threat to Apple through its growing product line including Chromebooks, Nexus and Motorola smartphones and tablets, Google TV, and Google Glass.

For most investments with this conflicting thesis, I would buy a long position in the shares with a covered call strategy in the options. With an outlook skewed to the bullish side, I may buy 300 shares in the stock and sell 2 call contracts in the long-dated options. While limiting the upside on 200 shares of the stock, the strategy gives me some downside protection.

But this is not really possible for investors in Apple. Since option contracts are only sold on blocks of 100 shares, an investor needs to put down a minimum of almost $50,000 to use a covered call strategy. This scale of investment is just not possible for most, even with the premium on the $500 strike January 2014 calls offsetting the price by $28.05 per share.

After a rumored 10-to-1 stock split though, a 100 share block of Apple would only cost $4,489 before collecting the premium on the covered calls.

Other popular options strategies would also be available after a stock split, including put writing. In this strategy, an investor sells put options on a stock instead of an immediate long position. If the shares close above the strike price, the investor keeps the premium paid and takes no position. If the shares close below the strike price, the investor buys the shares for the strike and keeps the premium. The cost basis for the shares becomes the strike price minus the premium collected, giving the investor some downside risk management.

I currently have a bull spread on 2015 Apple calls at the $450 and $460 strike prices. Investors with a bullish outlook on the shares may consider call options ahead of any split or dividend announcement to participate in the upside potential. After the announcement, a wider range of options strategies could become available.


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