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Sprint Secondary Creates Opening for Options Play

Brian Louis

Sprint's (FON) whopping upcoming secondary offering of stock holds an interesting trading situation for options players, according to a report that came out earlier this week from the derivatives team at Salomon Smith Barney.

Salomon, a unit of Citigroup (C), expects the offering, which is anticipated to be held this month, to "have a ceiling effect on Sprint for the next few weeks," keeping the stock in a trading range from which investors can benefit.

The Salomon derivatives squad thinks worried investors are going to sell into any strength in the stock and that Sprint bulls will hold off buying until after the secondary offering, two factors that are likely to limit Sprint's upside. That cap, if you will, can mean profits for investors using options .

In February, Sprint filed with the Securities and Exchange Commission for a public offering of 152 million shares of its stock to be sold by Deutsche Telekom (DT) and France Telecom (FTE). Sprint says it will not receive any of the proceeds from the secondary offering.

Deutsche Telekom and France Telecom plan to use the proceeds of the sale in part to pare down their debt.

The Salomon equity derivatives crew suggested in the report that investors who own Sprint shares should consider selling "slightly" out-of-the-money calls expiring in April. "This allows them to still have a bullish outlook, but also expresses the idea of a temporary cap on the shares," the report says.

Investors sell calls on the hope that the options will expire worthless, or below the strike price. By selling call options, the seller, or writer, is obligated to supply Sprint shares if the calls they sold are exercised.

Also, the report suggests, investors could consider that with upside potentially limited in Sprint's stock and a possible jump in Deutsche Telekom and France Telecom because of a successful offering, investors could buy "slightly" out-of-the-money Deutsche Telekom and France Telecom calls and sell "slightly" out-of-the-money Sprint calls.

The Salomon team said each side of the trade should be equal (or as close to it as one can get) in exposure. So, if an investor was selling Sprint calls representing $100,000 in Sprint stock, the investor would then buy call options representing control of $50,000 in shares in Deutsche Telekom and enough calls to bring about leverage over $50,000 worth of France Telecom stock.

Here's an example of that trade, with the following underlying prices as of Thursday: Sprint at $21.74; Deutsche Telekom at $24.41 and France Telecom at $59.75.

An investor could sell 100 Sprint April 22 1/2 calls for a notional value of $225,000. That figure is arrived at by multiplying the number of contracts being sold (100), multiplied by the number of underlying shares controlled by each contract (100), multiplied by the strike price, (22 1/2).

With Sprint April 22 1/2 calls trading at 1.40 ($140) on Thursday, the investor could sell 100 of the calls and collect $14,000 of premium for doing so.

For the purchase of the calls and to get an equal notional value as the Salomon trade idea suggests, an investor could buy 45 Deutsche Telekom April 25 calls for a notional of $112,500, and could then buy 19 France Telecom April 60 calls for a notional of $114,000 for a total notional on the buy side of the trade of $226,500. That's pretty close to equal notional value.

At Thursday morning's prices, the investor could buy 45 contracts for 1.70 ($170), or $7,650, and 19 France Telecom contracts at 3.60 ($360), or $6,840, for a debit of $14,490. The total net debit for the trade is $490 (the $14,490 it cost to buy the calls on Deutsche Telekom and France Telecom, minus the $14,000 the investor takes in for selling the Sprint calls, resulting in a net debit of $490).

The best-case scenario for this trade would be if Sprint shares stay relatively flat or fall and Deutsche Telekom and France Telecom rally. If the Sprint calls expire worthless, the investor would be able to keep the $14,000 premium taken in for selling the options. And if Deutsche Telekom and France Telecom rise enough, the investor will profit from being long the calls.

However, there is a worst-case scenario. If Sprint rallies, but Deutsche Telekom and France Telecom do not, those calls bought on the latter two companies would expire worthless and the investor would lose the money laid out to buy them. If Sprint advances, and the calls the investor sold are in-the-money and are exercised, the investor is obligated to sell shares of Sprint for 22 1/2.

Of course, before expiration investors can close out their positions in this trade (buying back the Sprint calls they sold and selling the Deutsche Telekom and France Telecom calls they bought) to mitigate serious damage.