Shaking Out the Weak Hands

January 14, 2013 (12:00 pm)

Déjà vu. The Wall Street Journal reported late last night that Apple cut iPhone component orders due to “weaker than expected demand” for the Jan-March quarter. The report went so far as explaining that Apple seems to have cut orders by 50%. By the way, the WSJ attributed this to “people familiar with the situation.” It feels like we’re in the Matrix. Haven’t we been here before? It looks eerily familiar… déjà vu.

On November 9, 2011 (during the year ago holiday quarter), Business Insider reported: “There’s a troubling new [Digitimes] report that Apple is reducing component orders from Asia suppliers because of sales and production problems with the iPhone 4S.”

The article suggested that not only were sales weaker than expected in the holiday quarter, but that Apple was decreasing orders for the March quarter as well. Shares of Apple fell 3% that morning. Interestingly, Apple absolutely crushed iPhone estimates in the holiday quarter, selling 37 million iPhones vs. a mid-20 million estimate. The shares went on to climb $225 in the ensuing two months following the report. Further, Apple also blew past March quarter estimates. Shares jumped over $50 the day they reported earnings. These articles are meant to spread FUD (fear, uncertainty and doubt) through the Apple investing world.

*1:20pm UPDATE*

We found another article from the same November 2011 time period. CNET reported “Slower iPhone 4S demand making Apple rethink supply orders. Although the iPhone 4S appears to be selling well, a new report claims Apple has pushed back some supply shipments in the fourth quarter due to lower-than-expected demand.”

Let’s assume, for a moment, that Apple actually did cut orders from its supply chain. There are two rational explanations that would not have negative implications:

  1. The iPod Touch. The Touch shares the same screen as the iPhone, which the WSJ speculated saw orders cut dramatically this month. iPod’s tend to see robust holiday sales, followed by a fairly dramatic fall off in the March quarter. Apple could be decreasing supplies for those specific devices.
  2. Yield. Apple could have very likely ordered significantly more supplies for its iPhone as it expected to make due to low yields. As production yields improve, they can decrease supplies without impacting the projected numbers to be supplied.

The timing of the latest report from the WSJ could prove extremely beneficial. It restrains expectations for the March quarter as we head into the December earnings report. With decreased expectations for March guidance, it will be even easier for Apple management to deliver an earnings beat, not only in January, but also in April. An enormous rally is even more likely thanks to this report.

Our Suspicions: So why does this timing seem suspicious? As we’ve discussed at length here and here, there are nearly a million Apple calls above the $500 strike price that expire this Friday. There are literally billions and billions of dollars to be made by large institutions and hedge funds that sold those calls. If they expire worthless, those institutions are able to keep the premium they collected on the calls.

To make a somewhat complicated story more simple, let’s look at a brief example. When you buy an Apple call option (let’s say for this Friday, January 18th), somebody is selling you that option. That seller is typically a large institution, hedge fund or market maker looking to create income. They receive the premium that you pay for the option. If that option expires worthless, they get to keep the full premium without payout you anything. If it expires above the strike price, they pay out an amount equal to the closing price less the strike price. So the lower the strike, the better for the option seller.

The Bullish Effect. One thing we haven’t discussed is how these institutions hedge their risk. Most often, option sellers purchase 100 shares of stock to sell a single call option (since a single option contract is for 100 shares of the underlying stock). So they own 100 shares and have sold a call. You may know this as a covered call. If the option expires in-the-money, the institution can simply transfer the shares they own to the option holder. But if the option expires worthless, they received a bit of premium and are now sitting with 100 un-hedged shares of Apple.

If we think about how this is likely to work, these institutions are likely to make out with a hefty profit. As we expected, the shares are down to the very low $500 level heading into options expiration. This will have the effect of wiping out all of the call options above the $500 strike price level. There are almost a million call contracts above that level. Assuming a majority of these contracts have been hedged, this represents almost 100 million shares (one million contracts x 100 shares per contract). Next Monday morning, when these calls expire worthless and these 100 million shares have no upside hedge, the institutions have an enormous to allow the price to run.

What else is happening next week, just after options expiration? Oh yeah… earnings. Which are likely to come in well above consensus estimates. So just as the largest institutions and money managers see their 100 million shares become un-hedged, there’s a huge catalyst that will likely force shares to skyrocket.

This all seems too convenient. We’re buyers in the low-$500’s heading into options expiration.