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Insuring a Winning Position With Out-of-the-Money Calls

Sometimes, when you time it just right, using out-of-the-money calls can put you squarely in the money.
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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.

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.

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. The site had this fantastic

article by

Justin Lahart

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

Remember, if the

Consumer Price Index

had been too high, you could expect that

Greenspan

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.

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.

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.

The Plays

I bought 500

AT&T

(T) - Get AT&T Inc. Report

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

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.

AT&T (T:NYSE)

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.

BankAmerica (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.

Best Buy (BBY:NYSE)

I bought 250

Chase Manhattan

(CMB)

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.

Chase Manhattan (CMB:NYSE)

I bought 350

Citigroup

(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.

Citigroup (C:NYSE)

I bought 750

DaimlerChrysler

(DCX)

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.

DaimlerChrysler (DCX:NYSE)

I bought 250

Dayton Hudson

(DH)

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!

Dayton Hudson (DH:NYSE)

I bought 250

EMC

(EMC)

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!

EMC (EMC:NYSE)

I bought 500

Gap

(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.

Gap (GPS:NYSE)

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 (GE:NYSE)

I bought 250

Hewlett-Packard

(HWP)

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 of Hewlett-Packard 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.

C'est la vie.

TheStreet Recommends

Hewlett-Packard (HWP:NYSE)

I bought 250

Merrill Lynch

(MER)

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!!

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.

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.

J.P. Morgan (JPM:NYSE)

I bought 250

Oracle

(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.

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.

Procter & Gamble (PG:NYSE)

I bought 250

Schering-Plough

(SGP)

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

Warner-Lambert

(WLA)

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

Schering-Plough (SGP:NYSE)

I bought 750

Tyco

(TYC)

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

(CNSP)

. Boom, another triple.

Tyco (TYC:NYSE)

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

TSC

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

TSC

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

Journal

and

CNBC

, or

CNBC

and

MSNBC

, or

CBS

and

CBS Marketwatch

, or

ABC

and

Go

, or

Time Warner

(TWX)

and

CNN

and

CNNfn

, 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 it is certainly not in any of these other media outlets to tell you about us, so we just have to do it ourselves.

Thanks.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long Tyco, Oracle, Microsoft, AT&T and Best Buy. 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

jjcletters@thestreet.com.