last week's mission of looking at upcoming earnings to establish option positions, here is another attractive opportunity. CheckFree ( CKFR), the electronic payment company, is scheduled to report earnings after the close on Thursday. It is expected to earn 31 cents per share on $182 million in sales for its fiscal second quarter of 2005. That would represent a 21% increase over the year-ago period. The stock's price-to-earnings ratio has contracted along with its growth rate in recent years; at $37, the stock is trading around 28 times this year's earnings, down from the Internet-like multiple of 50 it was sporting back in 2000. The earnings growth rate has slowed from 80% per year during the prior five years, and is expected to drop to the midteens over the next few years.
One thing I like here is that the long-call portion of the spread is currently $2 in the money, giving the position intrinsic value, which I believe improves the risk/reward ratio. Even if the stock stands still, the position will retain its $2 of intrinsic value, letting you recoup a large portion of the spread's initial cost. This contrasts with buying an out-of-the money spread. Although an out-of-the-money spread has higher profit potential, it's subject to greater time decay, requires a larger gain to realize a profit, and has a much higher probability of expiring totally worthless. After a nice price gain Tuesday, CheckFree's chart shows good support at $36, which gives me some degree of confidence that the $35 call will be at least $1 in the money. I'm also choosing to use relatively short-dated options. As I've mentioned before, it can be difficult to realize the full value of a vertical spread, even if it is in the money, if there is a long time remaining until expiration. That's because the two strikes still will have significant time value and essentially the same theta, which causes relatively flat pricing across the strikes until the options are deep in the money. For example, CheckFree's February $30/$35 call spread, which is fully in the money, is currently trading around $4.20, or 80 cents below its intrinsic value. But a $30/$35 call spread with a May expiration is trading around $3.50, or $1.50 below its intrinsic value. By using the shorter-dated options, you not only take advantage of the more rapid time decay of the further out-of-the-money call you've sold short, but the spread's full value can be realized sooner if this bullish thesis plays out. And if the quarter is a disaster and the stock drops, it's nice to know the risk is limited.