“The Market Can Remain Irrational…”

January 8, 2013 (12:30 am)

AT&T’s Estimated iPhone Sales

AT&T posted a press release this morning announcing sales of more than 10 million smartphones in the December quarter, topping its previous record of 9.4 million set in the December quarter of 2011. This included best-ever quarterly sales of both Apple and Android smartphones.

So let’s break this down. Last year, AT&T sold 7.6 million iPhones (80.1% of smartphones sales). That quarter not only included the launch of the iPhone 4S, it also lasted 14 weeks – a week longer than the current quarter. So the current quarter has two aspects working against it (a) the iPhone 5 launched at the end of last quarter, so it’s missing a big iPhone launch, and (b) it only includes 13 weeks.

The iPhone has historically represented between 75%-80% of AT&T’s total smartphone sales. So it is very likely that AT&T sold at least 7.5 million iPhones this quarter. This represents 7% growth adjusted for the additional week. Remember, this slight growth took place on the most iPhone-saturated carrier in the most iPhone-saturated market. We then need to look at sales to the numerous additional countries and carriers that were able to sell iPhones this holiday quarter that were not participating in the year ago quarter. And, finally, there’s the 800 pound gorilla in the room: CHINA. The Chinese introduction of the iPhone 5 had over two million sales in the first weekend. Last year, the introduction of iPhones didn’t commence until after the new year. Thus, all Chinese sales will be “incremental” sales this quarter vs. last year.

It is very hard to interpret sales from one U.S. carrier to extrapolate world-wide sales. As Apple becomes more of a global retailer (from U.S.-centric), it will become increasingly difficult to extract data to find wider-scale trends.

January Options Expiration

One reason the stock may be bouncing around the low $500’s, besides the inability for many fund managers to believe Apple’s story until after results, is the fact that January options expiration has an exceedingly large number of contracts. There’s a well known phrase “the market can remain irrational longer than you can remain solvent.” Many Apple-watchers see the current action as “irrational.” But is it?

The graph below illustrates ‘open interest’ in both call and put options that have a January expiration. You can see huge (green) spikes at the $600, $650 and $700 prices. Those represent the number of call options with a strike price at those levels. Similarly, you can see a significant number of puts (blue) at the same levels, with the highest number of puts at the $500 level.

Monthly Option OI

Who is writing (selling) these options? These aren’t your typical mom and pop retailers writing options. These options are written by the gigantic financial institutions – the Fidelity’s of the world. We don’t mean to single out Fidelity, but let’s use them by way of example. To simplify things, let’s just say that Fidelity wrote (sold) all of the call options at the following levels (from the chart above):

  • $600: 73,000 contracts sold
  • $650: 60,000 contracts sold
  • $700: 52,000 contracts sold

Now assume for a moment that Apple didn’t sell-off in September and instead went the route of climbing to $750 by January options expiration. All the buyers of those options would be entitled to the following amounts of proceeds (again, based on the chart above):

  • $600: $1,095,000,000 in proceeds
  • $650: $600,000,000 in proceeds
  • $700: $260,000,000 in proceeds

If Apple closed at $750 at January options expiration, the call holders would be entitled to an aggregated payout of approximately $2 billion (yes, with a ‘b’) from the institutions that wrote those specific options. Remember, that figure only represents three specific strike prices, not the full gamut. For instance, if you include the $500 strike price, you’d add $750 million to that $2 billion number. These add up extremely quickly.

So the buyers of these options are typically retail investors, hedgers and, in some cases, institutions. The sellers are made up almost entirely of “smart money” market makers and large institutions. These are the guys that have the firepower to move markets. To stay with the Fidelity example, at 9/30/12 the fund held millions of shares representing billions of dollars of Apple stock.The institutions that sell Apple calls, have an obvious incentive for the share price to close below the strike price of as many options as possible. Is it impossible that the firms with the widest exposure to Apple’s call options could have sparked the sell-off by putting large amounts of shares up for sale on the way down? As supply overwhelms demand, prices must come down. I’m not suggesting illegal manipulation or anything to that effect. But it is interesting to note that those institutions who sold all of the options that will likely expire worthless have saved themselves well over $3 billion in aggregate. The recent correction may not be so irrational after all.