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Cramer's Rewrite of His 'Insuring a Winning Position With Out-of-the-Money Calls'

The trader revisits his instructional column, charts and all.

You request it, you get it. People want more of this kind of story. Therefore, I want to give you more of these. I also want to get behind the philosophy of what goes on in options and talk a bit about how corrupt the business has gotten lately.

Out-of-the-money calls play with fire. They almost always go out worthless. They can add up to huge losses over time. They can be addictive because there is so little money out-of-pocket.

(I started this piece with this bit of boilerplate because I have, at various times in my life, been a call junkie. I don't want to encourage anybody to fall prey to the juice as I have at various times. When you buy calls that are out-of-the-money they are going to stay out-of-the-money much of the time.)

But occasionally, if you use them as an insurance policy, particularly against an upside explosion like we had this last week, they can be a fantastic use of capital.

(If you think of them as insurance, then you will accept the losses. We don't ever want insurance to have to pay off, but when it does we are glad. You don't speculate with insurance; it is a necessity.)

Earlier in the week, when the possibility loomed that we could have a benign big event, I was worried sick that I would miss a big blowoff to the upside.

(If I was long, why was I worried? Because at the time of writing, I had 50% of my money in cash. I am a performance manager. I risk my job if I miss a big up move. If I think that a big move up is about to occur, I have to find a way to participate without dipping into too much of my capital.)

The site had this fantastic

article by

Justin Lahart

that described just such a possibility. This article could have made you a small fortune.

(Call this cross-promotion, but I feel strongly that there is a lot on our site that is just dynamite and you may not be reading it. Lahart has had a huge piece on Japan that could have made you a ton of money recently, and he had this heads-up. I look for bylines that make me money. This Lahart byline makes me money.)

I used it as an excuse to convene a meeting with

Jeff Berkowitz

, my partner, to argue about taking out an insurance policy on out-of-the-money calls that would expire this week. The idea was if we could craft a portfolio of calls that were less than a buck on stocks that were close to the strike, we would be protected against a giant move up. I describe this as insurance because if the numbers were not benign, the week could be dreadful.

(So, to put this in dollar terms, I was trying to find a way to control about $50 million in stocks, without risking $50 million. For roughly $500,000 I was able to buy a basket of calls on stocks I thought would move up on a benign set of figures. These $500,000 worth of calls controlled roughly $50 million in underlying value.)

Remember, if the

Consumer Price Index

had been too high, you could expect that


might really lay down some enfilading fire on buyers in his testimony the next day. You could expect that any wrong number and your common stock portfolio could be obliterated. Given these stakes, plus a triple-witch option, you had to believe that something big could happen either way.

(Again, understand my mindset. I am worried that the market might have a short sharp rally. Many of the biggest moves each year occur during expiration week. A combination of a quiet CPI and a bullish Greenspan might just be unstoppable. But I have also seen markets drop 5% during expiration weeks. If I had put $50 million to work, I might lose upwards of $2.5 million. Here, if I put $500,000 to work, I knew I would be stopped out at $500,000 -- you can't lose more than you put up with calls. That stop-out appealed to me.)

That's precisely when out-of-the-money calls come in most handy. Remember, this strategy does not always work. If this were another week besides option expiration, this raft of calls might have cost me double or triple what they did cost. That would have been too much to lose.

(Calls lose value rapidly as expiration approaches. Calls can drop 25% between the Friday before expiration and the Monday before expiration. They can lose huge value overnight each night of that expiration week. Calls that I might have bought for $2 on Thursday the week before might be valued at $1.25 three days later. So this strategy could not be put on the week before. In fact, the identical portfolio might have cost me more than a million dollars if I had set it up on Friday the week before.)

I mention all these caveats because I do not want to encourage option use. But this strategy is such a good strategy that I shared it with you last week. I never mentioned which stocks, though, because calls are thinly traded and I did not want to front-run you and I did not want you beating me to the exits.

Now that the week is over, let's see how this strategy did. I will go over each trade. I want to go into detail because I want you to be thinking like me when these chances occur. Remember, I am never going to tell you what to buy. That's not my agenda. But when I show you my hand after it has been played, you will have a much better idea of what I mean and be ready for the next time this situation occurs.

(Some of you were openly critical of me for even detailing an out-of-the-money strategy at all. To that I say, I am showing you what I am doing and what works for me and what doesn't. I tell you what I do, not what to do.)

The Plays

(Many of you want to know how I picked these stocks. I did a screen of all near-term calls that sold for a buck and 1/8 or less with stocks that are fewer than three points from the strike. I tried to emphasize financials, or at least companies that could get a pop if rates went lower.)

I bought 500


(T) - Get AT&T Inc. Report

June 55 calls for 39 cents, or $19,500, when the stock was at 54.

(ATT has a giant floating rate debt portfolio. When rates go down, their costs go down and earnings go up. Therefore it is interest-rate-sensitive.)

These just made it, as the stock had been very heavy. I exercised these calls and will come in long AT&T on Monday, up a small amount.

(This trade failed later on and the stock got clocked when another Portland scare arose, this time a rumor that San Francisco was going to force open access on T's new cable buys. I rode the stock down and then back up but finished the week off 1/2.)


I bought 250

Bank of America

(BAC) - Get Bank of America Corp Report

June 70 calls for 64 cents, or $16,000, when the stock was at 68. I caught a triple on these when the bonds went ballistic.

Sold for $2.

(This stock sold off despite a giant buyback announced last week. I picked it because banks do great in a lower-interest-rate, low-inflation environment.)

Bank of America (BAC:NYSE)

I bought 350

Best Buy

(BBY) - Get Best Buy Co., Inc. Report

June 60 calls for 20 cents, or $7,087, when the stock was at 55. I was long 35,000 Best Buy when I bought these. When the stock zoomed up, I sold it and kept the calls and exercised them Friday night when the stock went out at 60 to keep my position on. I lost a good basis for a bad basis, but it was worth doing.

(Screwed this one up royally, as I sold it the day that it got added to the S&P 500. I even went short it at 64. I picked this stock though, for very different reasons. Many times I own a stock that I think is getting too pricey as it goes higher. I want the exposure to it, but I don't want the downside. So I replace it with out-of-the-money calls that at least will allow me to sell the underlying common and keep my hand in the stock.)

Best Buy (BBY:NYSE)

I bought 250

Chase Manhattan


June 75 calls at $1.01, or $25,500, when the stock was at 73. This was a five-bagger. As is often the case, the most expensive calls work out the best. I knew these were expensive going in, but I also knew that Chase was depressed by the bond market's bad behavior. When the stock exploded to 80, I jettisoned the calls for $5.

Good trade.

(Classic stock to own when rates are going down. Trades almost one for one. I thought these calls should have been about 3/4 of a dollar. That valuation comes from what I think looks right. I have a Ted Williams attitude about calls. I think there is a certain science to it, but not the kind of science they teach you at business school. Knowing that something is overvalued means nothing. Almost all of the stocks I have ever made big money with were overvalued. That's a meaningless concept.)

Chase Manhattan (CMB:NYSE)

I bought 350


(C) - Get Citigroup Inc. Report

June 45 calls for $1.28, or $44,800, when the stock was at 44 3/4. Here was an overpay -- I thought I should have gotten them for $1 -- but it was worth it as they quickly went to $2.25, where I sold them for a great return.

(I bungled this but still made money. The reason why it was bungled was there happened to be a large buyer of the common when I went in. I did not know that. I ran right into him. When there is a large buyer of the common, he is moving the stock as you try to buy it. That's why I overpaid. But the buyer just kept buying and the stock went right up all week.)

Citigroup (C:NYSE)

I bought 750



June 90 calls for 41 cents, or $30,690. I immediately got hit the next day by a neutral initiation by

Lehman Brothers

, which took a lot of lift out of the stock. Not to mention that car sales for June are not so hot. Nevertheless, when I came in Friday, the stock was at 90 in Germany at 6 a.m. and I was able to sell 40,000 shares. Later it dropped a dollar in New York to 89 and I covered the short. I picked up roughly $40,000 on the short for a profit of $10,000. Remember, you can always use calls to short common without fear of the upside. Had I waited until the stock opened in New York, I would have had a total wipeout. Early bird gets the worm, I guess.

(Here was a very confusing one. Many times I use out-of-the-money calls to short common against risk-free and then catch a decline. Let's simplify. You own DCX 90s for 3/8 of a dollar. The stock goes to 91. You can sell the call for a buck, a good gain, or you can short the common stock for 91. That's the exact same trade EXCEPT, if the stock were subsequently to drop to 85, say, you make six points when you cover the short. You lose 3/8 on the call, you make six on the short. That's a huge trade. You might never want to short DCX without that call though, because when you short a stock you always fear an upside explosion.)

DaimlerChrysler (DCX:NYSE)

I bought 250

Dayton Hudson


June 60 calls for 95 cents, or $30,690, when the stock was at 59. Figuring that the retail stocks were good for a romp if Greenspan didn't hammer us, I opted for a couple of retail situations. Dead Head, as everyone on the Street calls it, has been a coiled spring on the right numbers. It uncoiled perfectly, and I sold these calls for a triple. I could have had a five-bagger, as the stock got to 64 7/8, but that would have been pure greed!

(Retailers do great when the Fed is on hold or cutting, but these stocks react very poorly to rate increases. Some of that is because people feel less secure during rate hikes. Part of it is that retailers finance tons of merchandise on short rates, and when the short rates ramp, it hurts their bottom line. In this case, DH was down and down even more in advance of this week. So it was ripe for a bounce.)

Dayton Hudson (DH:NYSE)

I bought 250



June 50 calls for 95 cents, or $23,812. EMC is the classic kind of stock for the right numbers. It is the quintessential TSEL (The Stocks Everybody Loves), as it sells at a totally absurd multiple and moves like a banshee with a fire under its feet. I misjudged the move here and sold when I had a double. It would have gone up sixfold!

(Woulda shoulda coulda, this stock is one great-acting stock when it ramps. I ALWAYS play the calls on this one because it can really shimmy.)


I bought 500


(GPS) - Get Gap, Inc. (GPS) Report

June 65 calls for $1.12, or $56,000. I was sucking wind on these until Friday when

Morgan Stanley

highlighted the name and I blew them out at 3 for a nifty return when the stock exploded. I wish I had held on, though, as this stock looked very powerful all Friday afternoon.

(See Dayton Hudson.)


I bought 250

General Electric

(GE) - Get General Electric Company (GE) Report

June 105 calls for $1.15, or $28,750. I sold General Electric short at 107 1/2 against these for a gain of a little more than a buck.

(General Electric, the second biggest stock in the market, now seems to trade almost entirely with S&P Buy program related to interest rates. Rates go up, this stock goes down. Rates go down, this stock goes up. Very little, it seems, of what GE actually does affects the stock. This stock is the market.)

TheStreet Recommends

General Electric (GE:NYSE)

I bought 250



June 90 calls for 70 cents, or $17,562, when the stock was at 88. I screwed this one up. At 2 p.m., this stock looked stuck at the strike, so when it got a little lift, I sold 25,000 shares for 90 1/2. I figured if the market collapsed, I could have a nifty short in the last hour. Instead the stock exploded to the upside, and I left an easy double on the table. Jeff couldn't believe I took this one off as he thought this was worth bringing in on Monday.

(Again, this was one I should have let run. I think HWP may be getting it together and I think it remains a great spec.)

C'est la vie.

Hewlett-Packard (HWP:NYSE)

I bought 250

Merrill Lynch


June 70 calls for 79 cents, or $19,657, when the stock was at 68. The next day, Dan Dorfman reported on some Web site that Merrill was going to get a bid. Suckers came in immediately and took me out up $4 for a five-bagger. Thanks, Dan!!

(Here's the drill. You buy thousands of out-of-the-money calls on a stock. You call Jagnotes and tell them you have heard that Merrill is going to get a $90 bid from Chase. The rumor gets posted, and you get to sell the calls for a huge amount. If you don't think that's what's going on, may I gracefully suggest that you are out of your league.)

Merrill Lynch (MER:NYSE)

I bought 500

Mister Softee

(MSFT) - Get Microsoft Corporation (MSFT) Report

June 80 calls for 61 cents, or $30,440. Man, these were so cheap, but the stock was looking doggy, hanging at 77. The crowd (the people who make a market in these things) were way too eager to sell me these. They forgot the days when Microsoft could explode. And explode it did. I sold half of these at 3 and went home with the rest.

Eight times my money.

(When will this stock ever quit? Of course, I got the benefit of rumors of a settlement. Any rumor of a settlement really gets this thing going.)

Microsoft (MSFT:Nasdaq)

I bought 250

J.P. Morgan

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

June 130 calls for $1.09, or $27,312, when the stock was at 128. Again, this showed a willingness to make a big overpay because Morgan is considered heavily leveraged to the short rates and has a very high beta. Actually, these were a steal and I sold common short against them at 133. The stock quickly fell back to the strike, where I should have covered and done the trade again, but there was no supply, having been brought down by a program only. Instead of a triple, I could have had a sextuple. But still an excellent trade.

(This stock trades with a level of volatility that is shocking to me. Part takeover, part crummy specialist -- sorry, but I gotta tell the truth -- and part huge leverage to rates. JPM hops like a Mexican jumping bean. They ought to split it already.)

J.P. Morgan (JPM:NYSE)

I bought 250


(ORCL) - Get Oracle Corporation Report

June 25 calls for 1, or $20,250. I did this trade after believing that there could be no risk to losing a buck for a most unloved stock. This was my best trade for the week, as it went up 10 points: $200,000 profit. Stayed long it.

(This stock was way too hated. Any time a big-cap stock gets this hated, you will always see me buy calls on it. Too many people leaning the wrong way.)

Oracle (ORCL:Nasdaq)

I bought 250

Procter & Gamble

(PG) - Get Procter & Gamble Company Report

June 90 calls for 34 cents when the stock was at 88. What a tell this was. These puts looked way too cheap to me given a $90 stock's ability to run for the roses on the right number. But PG doesn't have any mojo anymore, and this one was a wipeout. The calls without pump are the worst.

(Dud! This stock doesn't have it right now. It will again, but it is dead in the water. Stupid buy.)

Procter & Gamble (PG:NYSE)

I bought 250



June 45 calls for 39 cents, or $9,750. This one suddenly sprung to life for who knows what reason. I was awestruck and figured Dorfman was juicing it with some bogus rumor about a



run for Schering-Plough. I scooted at $1.50, a nice return, no thanks to Dan, but thanks to some aggressive buyer.

(The drugs are so depressed that you can catch too many people out of them. I am in Bristol-Myers (BMY) - Get Bristol-Myers Squibb Company Report now for the same reason.)

Schering-Plough (SGP:NYSE)

I bought 750



June 90 calls for 90 cents, or $67,282. With the stock at 89, these seemed very expensive. But Tyco, even more than EMC, is on everybody's most-loved list. Heck, this one is one lean, mean money machine, and it made another acquisition that ignited the stock, the buy of my once beloved

Central Sprinkler


. Boom, another triple.

(Here is a company that seems like Cendant without chicanery. I love it.)


The Aftermath

Now before you say, "Cramer, you ridiculous braggart," remember that if the numbers had come in wrong, this whole portfolio would have been completely wiped out. That's hundreds of thousands of dollars ripped up.

As it was, this was the quintessential week to do this strategy, and I don't know how long it will be before we get another like this. But I am proud of two things: my hit ratio -- only the PG didn't work -- and my telling you that this is exactly what I was doing. I am proud of this because I got about 100 emails from people who did the exact same thing -- different stocks or in some cases the same, including Chase and Citigroup -- and everybody was thrilled with the results.

How We Can Help Each Other

On a personal note, I know I keep harping on the value-added of


in part because we can go on in depth, share strategies and really help each other.


is more than just a digital

Wall Street Journal

. It is a living, breathing way to help you make money and invest and trade better.

I hope you benefited from this one, too. If you did, all that I ever ask is that you tell people about us. As I listen to the endless, sometimes mindless, cross-promotion between the




, or




, or


(CBS) - Get CBS Corporation Class B Report


CBS MarketWatch

, or




, or

Time Warner






, I think to myself, man, I can't believe we are doing this all alone. But you are never, ever going to get this kind of information from those guys. It's just that these other media outlets will certainly not tell you about us, so we just have to do it ourselves.


(As I surf the Web, I cannot stress enough that the other guys just don't bring you this stuff. Am I tooting our horn? You bet I am.)

James J. Cramer is manager of a hedge fund and co-founder of At the time this piece was originally published, his fund was long Tyco, Oracle, Microsoft, AT&T and Best Buy. At the time of this rewrite's publication, the fund was short Best Buy, and long Bristol-Myers and Merrill Lynch. 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