I used to do more options pieces, frankly, because I used to do more options. But the premiums have been too rich to buy, but not rich enough to sell. The liquidity has been subpar and the trading range -- this market has done nothing since May -- has killed the upside and the downside.
Sometimes good options strategies can be the difference between a push trade and a great trade. Let me walk you through a
trade that we completed yesterday to give you a sense of how you can use a sophisticated but commonsensical strategy to squeeze a few extra bucks out of an otherwise blah transaction.
(The trade wasn't actually completed. I reopened it shortly after this article and closed it out on Friday into options expiration. I will go into that trade in some detail.)
Last week, when Best Buy was in a free fall owing to guidance that was not as powerful as the bulls were hoping for, we decided that the time was right for call options, not common stock. We wanted to capture the upside to the name without the unfathomable downside that you get in a retailer when things go awry.
(If you own common stock, it can be hazardous for many points if the stock goes awry. In those situations I love the stopout feature of calls. I know my downside from the moment the trade goes on. I can't lose more than the price of the call! That's when I like to use calls. I would not, for instance, use calls if the situation were something like a Chevron (CHV) or a General Motors (GM) - Get Report, where I would not fear catastrophic downside. I, of course, also wouldn't get the upside juice that makes the leveraged quality of the call so precious -- or dangerous.)
Plus, although we happen to like Best Buy, we are adamant that the upside in retail is capped by a restrictive
that will grow increasingly unfriendly the longer consumer spending keeps cruising on fifth gear.
(We got some welcome news on this front Friday when John Berry from the Washington Post penned a piece saying the Fed may not favor raising rates. It is really important that you get to know Berry's work if you are going to play this Fed game. I check the Washington Post online everyday before I go to work to see whether Berry has written about the Fed. Our Fed, unlike the U.K. for example, likes to send signals through the media about what is happening. They use Berry to get the point across. I know this; more important, other big players know this. For example, Ron Insana feels like this and he harped on this Berry article all day on Friday. The article drove the bond market and overrode a strong Michigan Consumer Confidence number and a strong housing starts number.)
The situation: The stock was at 59 1/2. The September 55 calls were at $5.25, paying 75 cents over parity to play.
(The word parity might throw newbies off. Parity means that it is equal to the common. If you had been able to buy the call for $4.50 when the stock was at $59.50, you would be buying the call at parity because the strike September 55 plus the call, equals the same price as the common. If you could buy it at $4.25, you would be buying it below parity. Everything is benchmarked off of parity. Calls are too expensive when they are too far above parity. I would not have done this trade if I had to pay $1.25 or more above what I paid because I would sense that the risk/reward would not be good enough. That's not some technical piece of software that tells me it is expensive. It is the sum of my experience.)
In other words, you could create Best Buy for $60.25 in calls with an automatic stopout at the strike price (you can't lose more than the call) vs. no stopout with the common.
(You might have thought, well, what the heck, why didn't Cramer just buy the stock and the September 55 put, which would have stopped him out just the same? One of the great wonders of options is that you would be dead right if you thought that. The puts cost 75 cents. Indeed, that would have been basically the exact same trade. Add 59.5 and .75, and you get the price of the stock as created synthetically by the call! But that's how it always works because they are equivalent trades. In fact, it is very rare that the put would be worth more or that the call would be worth less. They are almost always in balance. When they aren't, options arbitrageurs swoop in very fast to sell the part of the equation that is too rich or buy the part that is too cheap.)
We did it 500 times, meaning we bought 500 calls.
(We put up about $350,000 in capital to do this. If we had bought 50,000 shares, it would have cost us about $3 million. That's because calls are leveraged. That is the definition of leverage.)
The Street loves Best Buy, and a bunch of analysts reiterated their buys in the name after the pasting it took.
(This sounded cynical, but in truth, hasn't every reiteration of this stock in the last 10 years been dead on?)
That got the stock back to about 61. It hardly budged the calls, though, which went up only to $6.25.
(They don't go up much because deep-in-the-money calls tend to track perfectly with common. As they go higher they don't gain premium over parity, they lose that premium.)
Now we had a point gain in the calls if we wanted to take it. That could be a nice return, but nothing to write home about.
(If I did not know about shorting common stock vs. call -- the strategy covered here -- I would have sold the call for $6.25 and been content with a decent trade.)
But I felt that Best Buy might offer more potential as a long-call/short-common situation. So instead of selling the call, we sold common stock short against the call at 61. That locked in less of a gain (75 cents before commission and exercise), but it put us in a situation to profit from any further deterioration in Best Buy's stock.
(We basically created a second position on our sheets, rather than close out the first. We have a call we are long and common stock we are short against it. Imagine if we had bought common stock in the first place. This strategy would be the equivalent of being long the common and short the common. The difference is that below 55 I would not be long the common. I would just be short the common. It is a free shot at the downside, as if I own the September 55 put.)
Sure enough, that is just what we got. The company subsequently announced earnings and did not wow the Street. Plus, it proved to be late with its Web offering, which for some reason, is still a mortal sin.
(The cynical garbage we have to put up with about the Web. Did you catch that ridiculous tracking stock panic play by Staples (SPLS) because the stock went down so low? Makes me sick, these cynical games managements play when they have misjudged their own weaknesses.)
The stock plummeted to 54, a point below the strike. At that point, my partner,
(I was out), shrewdly covered three-fifths of the common stock. (We are covering the rest today.) Now, instead of just making the point that we would have had, we sold the call outright. We made 7 points (61-54=7), minus the cost of the call ($5.25), or $1.75 on the 30,000 shares.
(In other words, go back to that example where I said we were basically long and short the same stock, but that the long side was stopped at 55. As soon as the stock got to 54, we had made an additional point by buying back the common.)
It gets better. Not only did we pocket 75 cents more than if we had just sold the call, we can now play the upside on a bounce if Best Buy does better.
We still have the call!
(This is exactly what happened. And sure enough, on Friday this stock rose from the grave and we sold the common against it for $56.375 to close out the trade, as it was expiration day. That means if you are long the call and have common sold against it, the position disappears as surely as if you sold the call. That's what expiration is all about.)
Or we could have sold the call at the end of the day at $1.50. Let's walk through the arithmetic on that. If we had sold the September 55 call for a buck and a half at the close, we would have made $7 on the common, minus the cost of the call ($5.25) plus the $1.50 return from the sale to close of the call. That's $1.75 plus $1.50, or $3.25 on an investment of $5.25. That's a huge hit from an otherwise lackluster trade. That's a gain worth crowing about.
(Again, you must constantly contrast this against your basis on the call. This is a rate-of-return trade that is magnificent vs. the plain old buy-the-call, sell-the-call.)
Turning busted trades into winners is part of outperformance. Our turn in Best Buy was simply found money that would have been left on the table had we not thought creatively.
(Watch this stock. It went out very strong on Friday. If retail begins to get more favored, it could be okay again.)
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 securities 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