Apple (AAPL-NASDAQ) is the second largest company by market capitalization in the US market, just ahead of Microsoft and behind Exxon Mobil.

If there is one company that has established an up trend in sales, earnings and share price, it’s Apple. Its most recent earnings release blew away estimates. Granted, Apple always low-balls its numbers. But its revenues came in at over $1 billion MORE than estimates and earnings came in at $3.33 per share, 90 cents higher than estimates. And its cash position swelled to $41 billion.

Consider that it accomplished all of this while the US and the rest of the world was in the throes of a stinging recession, and the numbers become all the more incredible.

What Apple has proved beyond a doubt is that its product line is not only superior to its competitors in terms of innovation, but that it’s marketing efforts are also unparalleled. When it comes to new gadgets – and there are thousands to choose from – there is no louder buzz than the one that precedes the launch of a new Apple product. But that’s only half the story…

Several Steps Ahead of the Game

In order for a product to succeed, it must meet expectations. In the case of Apple, its products have exceeded expectations and have proven to be durable and reliable.

Another indication of a successful product line is longevity. In the latest quarter, Apple sold 11 million of its iPods, the device that started it all. That number was the biggest surprise to Wall Street, since they were expecting less than 10 million units to be sold. It’s hugely successful iPhone is now in the hands of more than 50 million people, and the newest product the iPad is flying off the shelves… I know this for a fact.

About three weeks ago, I received a call from a friend in Canada who wanted the iPad for his 11-year old daughter’s birthday. They are not available in Canada yet. I couldn’t find one at any authorized dealer. I asked why he was buying such an expensive gadget for an 11-year old – the unit retails for more than $500. His answer was that her iTouch was too small!

The Key To Apple’s Success

Apple’s success is – in my opinion – due to its ability to deliver a pleasant tactile experience to the user. It has taken what is essentially a solid-state hard drive and made it functional to the nth degree.

While not a pioneer in touch screen technology or storage technology, Apple has taken both forms and made them appealing and easy to use. And because of the quality of the product, it has been able to charge prices that while higher, are not proving to be a barrier to consumers regardless of economic conditions. Apple’s continued success is going to be the result of the following:

• Penetration of global markets. Apple’s newest product lines are still by and large just a US phenomenon. There are few if any Apple stores outside North America. There are no “legal” iPhones or iPads in places like India or China… or most of Europe for that matter.
• Increasing profits from Apps, which are applications formulated to run on Apple products by independent developers. There are thousands of apps ranging from those that allow for GPS style functions to video games and dating services. Apple receives close to 30% of the revenues generated from these apps while doing nothing other than producing the product.
• Strong market shares from the iTunes library where consumers download songs, videos, etc. at a fixed price
• Future growth from downloading much larger products, like movies and books to devices like the I-pad.
• Migration. One of the biggest and less publicized benefits to Apple is the cross-selling opportunity to users for Apple’s Mac line of personal computers. Once people accumulate Apple products and familiarize themselves with Apple technology and operating systems, they are more open to buying into other Apple products. Mac sales have shown double-digit sales growth.
• Apple is one of the most recommended brands in the world, and the most recent studies on consumer buying habits have shown that people base 90% of their buying decisions on recommendations.

How to Play It

At $260 per share, Apple is out of reach for most investors. There is another way to get into this trade. Don’t think of it as “well, I missed the run from $120 to $200, so what’s the point?” Instead, think of it like this: Apple may be heading to $400 in the next two years and that means there is a big move ahead.

Many investors make the mistake of thinking that you have to measure gains from $0, instead of looking at where the shares can go from current levels. Is there a difference between $0 to $70 and $70 to $140? I don’t believe there is if both targets are achieved.

To make this play work, the ONLY strategy I would use is a Bull Spread.

A Bull Spread? What the heck’s that?

Ok, here’s the quick and dirty…

When you execute a bull spread, you need to buy one option and sell another one. You buy an option at a lower strike price and you sell another option against the one you bought at a higher strike price. The difference between the two strike prices is called the spread and the fact that you are betting on an upward move in price is where the bull comes in.

Bull Spread, not Bull S*&#

My price target for Apple shares is $400 by the January 2012, about 18 months from today. Apple is just ramping up its sales right now and the world is its oyster… There are many, many more buyers out there who are dying to get their hands on the product than who already have it.

Earnings are growing by a factor of 50% year-over-year for the shares, and they are trading at a P/E of about 25 right now: half the projected growth rate. Based on just a 20 price earnings ratio, Apple could easily be trading at $400 by 2012 by earning $20 per share, a number that reflects its underlying growth rates.

So, the play is to:

• BUY the Apple January 2012 $300 CALL LEAPS (AAPL JAN12 300C) currently trading for $36 per contract. (Each contract equals 100 shares, so you have to multiply $36 by 100.)
• And against this position, SELL the Apple January 2012 $360 CALL LEAPS (AAPL JAN12 360C) currently trading at $20 per contract.

Your NET Cost is going to be $16 per contract ($36 minus $20) and your upside is the spread or $60. So you are risking $16 to make $60 on this trade, and the MOST you can lose is $16 if you hold the trade until expiration. $16 is about 7% of the current share price.

As Apple shares move higher, the value of your investment will also increase and we will likely liquidate the position early. What we are looking for here is continued upward momentum in Apple, not necessarily a move to $360 or $400. And if Apple moves lower in a market correction, we will buy back the higher priced calls early and leave our upside unlimited.

Now the prices will be different when you read this. The net price of the spread will remain between $16 and $17.50 and you should use that as your guideline to get into the trade. I know all of you cannot or don’t want to do spreads… I hope this detailed recommendation will change some of your minds. There are some opportunities that we just shouldn’t pass up.

Karim