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

The trader takes readers through a strategy that paid off for him recently.
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Call premium has been so rich for so long that I haven't had much occasion of late to use options to play the upside. But a few weeks ago, after a trip to Williamsburg's Busch Gardens, I was struck by the number of youths wearing Abercrombie & Fitch (ANF) - Get Report 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 came back from Virginia and made a bunch of calls to analysts about the youth retailer and all the feedback was positive. 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.

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.

Or so I thought.

Seeing that the calls had no premium, 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.

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.)

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.

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

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.

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.

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.

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 AOL and short Abercrombie & Fitch. 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.