I want to do something different this week. I talked about a strategy that I used to protect myself from downside
last week, and I would like to spend some time on it.
The strategy in question involved
and how I like to approach momentum stocks. When Rowan ran up from the teens to the 30s, I began to believe that the stock had made too much of a move. I am not averse to taking gains, so I sold the stock. But I wanted to stay in. I was not sure whether Rowan would keep running. At its top it sold at 15 times earnings, but if there were some move afoot that would lead to this group getting a premium multiple -- I know, I know, seems silly now that Rowan is at 12 -- I didn't want to miss another ramp.
So I bought November 35 calls for four bucks, when the stock was at 38. In other words, I paid a dollar over the stock price for a call that would allow me to get the same benefit from the common stock without any risk below 35. That's where the call would expire worthless. I did this with two months to go before the November expiration.
Let's talk about the pros and cons of this strategy. First, it lets you feel that you know exactly what your downside is. In a vicious market filled with erratic, exaggerated moves, this ain't such a bad idea. You can sleep at night even if oil plummets, or someone downgrades, or the group erases its move.
Second, it gives you a ton of flexibility. Had I been prescient enough to see the big decline coming, I could have shorted common stock against the call for 44, and then have a free short below 35 -- protected to the upside by the call. What a fabulous situation that is. As an institutional account, I would also get a rebate on the interest received from the proceeds of the Rowan short -- a rebate that could be a couple of thousand dollars on a large position. (When you sell a stock short, you get the proceeds. Interest accumulates on those proceeds, and you can get some of it if you check with your broker. Not all firms will allow you to get that rebate, so
check with your broker.)
But the downside is that I will be generating another tax event, I will be racking up more commissions and, if Rowan does nothing, then I will have to put the position on again with more commissions! I will have put a November gun to my head, forcing me to address a situation when I probably don't want to.
And I have to pay that premium over the common. I could have just bought a put, but that put should cost the same amount as the cost of the call over the common. (I paid a dollar over the common for the call; the put would probably cost a dollar, too.)
In hindsight, the strategy was brilliant. The stock collapsed. I did not get hurt. But options are for high-risk players. Someone who misreads this Take Two might think Cramer is saying options are better than common. I bought a call for four; it went to zero. That's a 100% loss. Nothing to be proud of.
James J. Cramer is manager of a hedge fund and co-chairman of TheStreet.com.
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 by sending a letter to TheStreet.com at