Komag and Cree: A Double Option Play

Lenny Dykstra

The shorts kept piling on Komag(KOMG), as witnessed by the heavy selling yesterday, and the pummeling looks like it will continue today. If I didn't know any better, I would have thought they were closing up shop as I watched yesterday's panic-selling.

That said, let's take advantage of the deep-in-the-money (DITM) call strategy. The recent selling has given us the opportunity to control another 2,000 shares of this $23 stock for only $3,000 by placing a limit order to buy 20 contracts for $1.50 or better on the September 25s (QKXIE). For that $3,000 we can control an amazing $46,360 in stock (as of yesterday's $23.18 close).

I buy deep-in-the-money calls with four to six months until expiration in order to protect against a situation like this. It allows ample time for the stock to recover from negative news, and fill in the gap back up to where its value should be.

I often assert that the market exaggerates extremes in both directions, and nowhere is that point clearer than with Komag. The company was the victim of unfortunate timing, as it lowered guidance in the face of an unstable market. To a large extent, the concern over this year's earnings has already been priced into the stock. Once some shorts cover and buyers re-enter the picture, the stock's fundamentals and small float will deliver a quick turnaround.

Now for today's pick.

The next time you have a bright idea, instead of a light bulb over your head, you may have to rethink the image and replace it with an LED. Those little red lights on the VCR, alarm clock or coffee maker are light-emitting diodes, commonly known as LEDs, and their future is indeed bright as LED technology, which is looking to be the "go-to" technology as traditional incandescent bulbs begin being phased out of common use over the next five to 10 years.

Cree(CREE) announced Wednesday that it had just reached a development milestone by creating a defect-free silicon carbide 100-mm wafer. The company's financials are glowing as well. Cree's 2006 earnings came in at $423 million, zero debt and free cash flow of more than $265 million.

Yesterday I highlighted Color Kinetics(CLRK) as a potential investment opportunity because of its position in the LED market. But Color Kinetics has made a run up recently, so its deep-in-the-money calls come with too high a premium. With Cree, not only do we have the potential to buy an innovator in the field with an impeccable balance sheet, we also have the ability to gain increased leverage using DITM calls.

With the stock trading near the 21-day and 50-day simple moving averages, and overtaking the 200-day simple moving average at yesterday's close of $21.84, this presents a nice time to move into a DITM call. I have placed a limit order to buy 10 contracts of the December $17.50 (CQRLW) calls for $5.40 or better. This allows us to control 1,000 shares of a company on the cutting edge of technology for more than six months.

Fielding Reader Email

Enjoy your column! Could you go deeper in the money and go out longer to get a higher delta or does that require too much capital for the reward? Keep up the good work!

You can always go deeper in the money, but remember, the deeper you go the higher your exposure. I select DITM calls that go deep enough to provide downside protection, but not so deep that I overexpose myself.

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I've begun following your DITM call strategy, but I'm unclear on the significance of the "DITM next buy level" column on your scorecard. Please explain.

The "DITM next buy level" column is one of the most important features of the weekly Stat Book Scorecard. This column shows readers the point at which we should increase our positions in a DITM call.

When I make stock selections, I make them at a price and time I like. If that stock goes down in price, it becomes even cheaper and makes me like it even more. The next DITM buy levels represent the next opportunity to build positions and increase potential profits.

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