A Rewrite of 'Long Call, Short Common: One of Cramer's Favorite Positions'

The trader revisits a Tuesday column that took readers through a strategy that paid off for him recently.
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(For most of my years on Wall Street, I have traded options as much as I have traded common stock. First, I started with options because I didn't have any money but I had a ton of ideas and I wanted the leverage options give. Later, I traded options as proxy for common and kept a considerable cash position during periods in which the short rates were high, i.e., you got paid to be in cash. I often use options as a way to speculate. I rarely sell calls and never sell puts, but all of my reasons can be found by going to the Best of Cramer section and scrolling down to when you see options. If this were not on the Internet, I would, for the four billionth time, give you my reasons why I don't "write" calls or puts, but, heck, that's why this medium is so much better than paper.

This piece touches on a method of trading that I have used for about a 10 years. It is a complex method, and it was not understood by all. So, we will take it slowly and break it down to you can include it in your arsenal. Remember, I am here not to tell you what to buy, but how to be most effective at buying or selling, whether you are a trader or an investor.

Strategies like the one below would never ever work during the bad old days of high retail commissions. But now, despite its complexity, you can consider using this strategy if you are a call player. I apologize in advance for the length of this piece. I don't feel I can go on for 2,500 words except on weekends, which is why I have been saving these longer pieces for then. People just don't have the time or the inclination to read 2,500-word pieces while at work -- sorry Slate and Salon but that's the awful truth.)

Call premium has been so rich for so long

("rich" means that calls are expensive relative to their historic norms. A call is simply the right to buy something at a certain date in the future. Sometimes that right is priced cheaply, other times it is priced expensively. There are a number of reasons why calls can be expensive and I don't want to go into those. What I am saying is that it has been a loser strategy to buy calls as a proxy for common because you are paying too much for them relative to the common.)

that I haven't had much occasion of late to use options to play the upside.

(If you can buy

Abercrombie & Fitch

(ANF) - Get Report

at $92, but an ANF 85 call at 7.5--85+7.5=92.5, you are getting a good deal because if the stock drops 10 points you will be stopped out at $85, where the "strike" is. The cost of that call is only a half dollar more than the common, but you only have to put up $7.5 instead of $92. When I went to do this, though, the 85 calls were at $10, or $2.5 more than was reasonable to me. That meant if the stock went to, say, $82 I would still lose the same ten bucks I would have lost if I bought the common. That's a kind of working definition of "expensive." So, I bought a call that was "deeper" or had a strike at the $80 level, as we shall see.)

But a few weeks ago, after a trip to Williamsburg's

Busch Gardens

, I was struck by the number of youths wearing Abercrombie & Fitch clothes, and I wanted to get long ANF. I had played the stock off and on, but had stayed away from about 80 on.

(I had been in this stock for some time and then left it. Obviously it has a buzz and lots of momentum, but that's not the point of the piece.)

I came back from Virginia and made a bunch of calls to analysts about the youth retailer and all the feedback was positive.

(When I like a store stock, I don't just go buy the stock. I research how the company is doing, typically by reading research reports and talking to analysts. I just want to be sure that I am not coming in late. A few years ago, I went to my first

Applebee's

(APPB)

and liked it very much. It had just moved to my area. I wanted to buy the stock, but it turns out that I was late to Applebee's story, and that its growth had already been factored in. In fact, it had been struggling of late. A week later, Applebee's preannounced lower-than-expected earnings. I don't know how early or late I am to ANF, so I wanted to check to see what people who KNOW IT BETTER THAN I DO were saying or thinking about it.)

Still, I knew ANF to be extremely volatile and I didn't not want to be in a situation where the stock could get hammered, a la

Fila

(FLH)

or

Nike

(NKE) - Get Report

, two other fashion specs from a couple of years back.

(When you buy a fashion momentum stock like an ANF or a

Reebok

(RBK)

or a Fila, you have to understand that these stocks stay red hot until their moment of impact, when they just gaff your eyes out. It is vital to understand that hitching your star to ANF may mean that you can crash and burn through levels you didn't expect to see, as this piece can show you.)

So, instead of common stock, I bought 400 calls, the ANF May 80s, with the stock at $91.50. I paid a dollar and a half over parity, or about $13 and then, when the stock ran up in anticipation of a good quarter, I closed out the position.

Lots here. Instead of buying 40,000 shares of the common stock for $91.50 each, I bought 400 calls--which is the equivalent to 40,000 shares (each call is the right to buy 100 shares, so 100 x 400 =40,00 shares). Obviously, I am paying much less in actual dollars to establish a position in calls than I am in common. The advantage of this is two-fold: I get to use the money I would spend buying 40,000 shares outright in other ways, including keeping it in interest bearing treasuries, and I limit my loss to $13 per option as opposed to $91.50 per share. That will prove to be important, although not as important as I would have liked this week. Parity means equal to the common. If I had been able to pay $10.50 for the call, I would have been buying the call flat, or in line with the column, no premium. Here I add the call to the strike, $13 plus $80, which equals $93, and I subtract the common stock price, $91.50, and I get my premium, which is a buck and a half. That's decent, meaning it is not an overpay. There are very sophisticated models and theorems that tell you whether you are overpaying. I don't use them; I go on instincts and conviction. Some of you may think that is wrong, I don't care. When I wrote that I "closed out the position," that implied that what I did was sell the call. When you buy a call, you buy it to "open," and when you sell a call, you close it to call -- unless you are shorting the call to start, which is a whole other discussion. I was buying a call to open, and I could have sold it to close. Instead I did the following, which is key to the strategy.

Or so I thought.

Seeing that the calls had no premium,

(I may have paid a dollar and a half over the common stock in premium, but when I went to sell the call, the call was "flat" with the common, meaning the premium had disappeared. That often happens as a function of the common stock going up and the call being deeper in the money, or when you get close to expiration and you run out of what is known as the time premium of the call. Think real estate. If I give you an option to buy some land for a year, that's a better deal than if I give you an option for a week. You would pay more for the year. In this case, I was bumping up against expiration Friday and the calls were "shrinking" in value even as the common stock was going up. That is a common problem with all calls. I call it the "gun to your head" drawback of calls.)

I shorted common stock against the calls and kept the position on my sheet. In other words, I was long call, short common, which has long been one of my favorite positions.

(Boom, guts of the piece. When you want to take off a call, or close out the position, you don't have to sell the call. You can sell common stock short against it and not exercise the call. You can keep the position on your sheets and hope lightening strikes, which it almost did in this situation. This position is called long call short common and it is a killer position that should be part of any sophisticated trader's arsenal.)

It turns out that not everybody was too happy with the ANF quarter. Soon the stock started plummeting. That put me in an interesting pose, because below $80, I would be short common outright. (The call, struck at $80, would trade down with the common to $80 but then play no role, while I would continue to gain from the short below $80.)

(So, let's see what happens here. Let's say ANF reports a shortfall, and gets cut to $74, or the market has a giant correction and it drops that much. Something bad happens. I own a call that I paid $13 for. I am short common stock with a $94 basis. Had I sold the call flat with the common, I would have made one dollar -- $14 minus $13 equals $1. Now, instead of selling the call, I short common stock at $94. The stock breaks to $74. I lose $13 on the call because it is worthless. But I pick up $20 on the common short, when I buy back the ANF at $74. Now, instead of making the $1, I have made $7 -- $20 gain on the short minus $13 entry fee on the call. That's a much better return, and all I had to do was keep the common stock short and the call long. It is a windfall.)

On Tuesday, I bought 5,000 of the ANF back at $82. That left me long ANF above $80, 5,000 times, but short 35,000 ANF below $80. Or, put simply, if ANF went up, I could sell 50 calls -- the equivalent of 5,000 shares -- but if it went below $80, I would profit one for one all the way down.

(Okay, I got frustrated thinking this stock would go below the strike, so, I bought in some of it. I had a series of options then. I could have immediately sold the 80 call, which was at $3 at the time, or a dollar over parity. That's still the same $1 I would have made if I had sold the calls at $14. I could hold it for further appreciation, or, I could sell the common back out, which is what I ended up doing at $83.5 on Friday -- when the stock finally rallied.)

What is the virtue of such a position? First, it is a nice hedge without any risk. (I have created the May 80 put synthetically.)

(After all, what I have done here is allowed myself to profit from the stock were it to go below the $80 strike. I think you would have found that when the stock was at $94, if you had wanted to buy an $80 put, you would have had to pay a $1. That, after all, if what I was creating here, by selling common short against my call.)

Second, I earn interest on the proceeds of the short sale. (The short-interest rebate that my broker pays me.)

(Complicated point. Many of you disagreed with me here, which is strange because, heck, I have been paid millions of dollars in short interest rebates over the years as a professional trader. Many firms will not rebate that short interest, so maybe I should not have said it, but I want to tell you how I make money. When I sell 40,000 shares of ANF short, I still get paid the proceeds whether I own the stock or not. With those proceeds, I earn interest. That's the hidden subsidy of this strategy that makes it so palpably great. Without the short-interest rebate, it is still a good strategy. But with it, I get paid to keep this position on my sheets by the brokerage house, paid with the interest I earn on those admittedly "phantom" proceeds, because I, of course, did not own the stock that I am selling, just the proxy of it -- the call.)

Third, I now have a call that I can sell that may have some premium, as ANF is a volatile trader and the call will not trade "flat" with the common.

The other homerun here is that after I cover the common stock, or buy it back, with a stock like ANF it is always a possibility that it ramps right back up. Then I can sell the call. So let's go back to that example where the stock falls to $74. At that point, I cover my short. I still own the call. Now the stock ramps back to $85 and I sell the call for $5 (or sell the common again.) I am picking up an extra $5. Now I have made a $20 gain on the short and sold the call for an $8 loss, for a gain of $12 on an investment of $13. Nirvana. And it has happened just like this many times. (In the end, I covered the rest of the common at $81 and then sold it right back at $83.5 for an additional pick-up of a couple of bucks over if I had just sold the call outright. That's a win, and if you put enough of those wins together, you have a good year.)

I used to have positions like this on all of the time. But they have been scarce on my sheets of late, because call premium, or the price above the common stock that you have to pay for a call, is way too high and this strategy only really works well when there is little premium.

(In other words, had I had to pay $16 for the call, it would not be worth it. I would be out of pocket too much money, and it would be in the hole the moment the trade was put on because of all of that premium.)

I used to create these synthetic shorts regularly. For example, I would go long the

Intel

(INTC) - Get Report

May 50 calls for, say, $8.25 and a half, and short common against it right here at $57 and change, betting that at some point I could take the trade off profitably. If I didn't, I would just be out the premium, which would be pennies. If the company blew up, I would make a fortune. If it traded down to the strike, I could make money covering common and selling the call, or just keep it on to play the volatility.

(Here, again, if Intel reports a shortfall, I have a huge hit. In the meantime, I am paid the rebate on the short common stock.)

But after October of last year, call premium rocketed, and I have never been able to risk just pennies. Calls have been way too high vs. the common.

Occasionally, like in ANF, the strategy still worked. But it is a rarity these days, so I use it sparingly. As it came up in the

AOL

(AOL)

chat, I thought I ought to go into more detail about how it works, and prep you for such trades if call premium ever returns to more normal levels.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long America Online. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

letters@thestreet.com.