An Options Trick to Use With Those Doggone Rumors

How Cramer reacted to a headline about a possible merger.
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The headline flashes, "Warner Lambert, Schering-Plough hold talks, person says." It doesn't matter that this kind of "reporting" should barely pass for journalism.

Bloomberg

is breaking the story so we have to live with it. (Where are the journalism police for this stuff?)

What do you do? Do you ask yourself who is "the person" and whether "the person" may actually know anything? Do you call the companies and see if they are in talks? Do you even bother to read the article? Do you make a judgment that, with the price up 5/8 to 48 1/2, the stock reflects the news and it is too late to play, even if

Maria Bartiromo

may squawk it in another minute or two, giving the story more legs than it deserves?

I didn't do any of those. I reached for the May 50

Schering-Plough

(SGP)

calls and bought a boatload for a three-eighths of a dollar, with a day to go before they expire. But not because I thought the story was true. Even if it turns out to be true, for all I know, the "person" was someone who owned both stocks and wanted them to pop -- and who bagged some hapless

Bloomberg

reporter on a slow news day. I bought the calls to take advantage of an options trick I love to use. So, let me tell you about it.

I snare 400 of these cheap out of the monies, confident that, unlike a bet on the common, I am going to lose less than $25,000 if this story just goes away. That's the price of admission to play the rumor.

Mentally, I know these calls have little viability to win the takeover upside unless there is a deal Thursday night. But I don't care about that. What I really wanted was the free protected short on SGP in case some monster fund or speculators bought aggressively into the rumor. I wanted to profit from their failed attempts.

And that is just what happened. The next day

CNBC's

Bartiromo went out with the merger story, which, I guess, was too irresistible regardless of its veracity, and the stock popped to 50.625. At that point, I sold 40,000 shares of SGP common. Before commissions, I had made a quarter of a point, hardly worth the effort. (The call established a basis of 50.375 -- 50 strike plus .375 per call. The common sale closed out the position at 50.625. 50.625 minus 50.375 is a quarter-point gain.) But rumors without substance don't live very long in this market. As neither stock stopped trading and nobody surfaced to add additional credence to the story, both stocks collapsed.

That's how I made my money. By midday, SGP was hovering around the 49.375 level, off more than a buck from where the mob had taken it. There I swooped in and bought back my stock that I shorted at 50.625. So, I had now made a buck and a quarter on 40,000 shares, and lost the three-eighths of a dollar on the call. That gave me a per-share profit of seven-eighths of a dollar (1.25 minus .375) for 24 hours work.

For all I know, tomorrow these two companies will get together. I don't care. I have no way of knowing that. But I do know that, psychologically, the easy money to be made was to bet against those who put credence in the rumor, without risking a head-slamming short squeeze.

That's why this strategy works so well.

Random musings:

I am conscious that this type of article can't be breezed through. But I had such good feedback on my "Long Call, Short Common"

piece that I will try to do more of these so you keep getting your money's worth of stuff that I know I haven't read elsewhere ... Abelson's back in

Barron's

with some gratuitous slam of

TSC

and me this weekend. I quote my wife, the Trading Goddess, "doesn't Abelson know that everybody is bored to tears with reading about you already? At least he doesn't bother writing about the 1975 Crimson election that so many of your hack journalist friends seem obsessed about." Truer words?

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. 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.