Are there instances in which you might be long a stock, then also choose to be long calls on the same stock? The answer is yes, and it shows why the inventor of options (whoever he or she is) should be enshrined in the Wall Street Hall of Fame.
There are three really great reasons to implement this strategy:
One reason might be in anticipation of a strong earnings report. Suppose you are long shares of IBM (NYSE:IBM). It trades at $195. You foresee a blockbuster earnings report, but want to hedge buying even more shares, in the event you are wrong and the stock craters (as they can do even on a great report that misses expectations).
You buy some October 195 calls for $5.40, betting that the stock will leap more than that amount before expiration (three days after earnings, in this case). That way, you spend $540 per contract rather than risk $19,500 in the event things don’t go your way.
Another circumstance might be if you lack the liquidity to buy more of a stock you are bullish on. Let’s say you are loving McDonald’s (NYSE:MCD) and are long the stock. However, you are cash-poor and don’t want or don’t have margin capability.
The stock trades at $89. If you buy a deep-in-the-money call — such as the October 80 Call, for $9.48 — you are eliminating the extrinsic value of the option, only exposing you to the price movement of the underlying stock. So when expiration rolls around, you sell the call, netting either a gain or loss tied directly to the stock’s movement during that period. You’ve gone long the stock for $948 instead of $8,900.
The other reason is tied to an article I just wrote about speculative buyouts. In the case of Coinstar (NASDAQ:CSTR), I am long the stock and have considered buying some out-of-the-money calls for, say, April. I figure if a buyout is going to happen, it’d happen by then.
The April 55 calls are going for $5. So I have to grapple with the risk of $500 for each contract, betting that any buyout occurs for more than $60 a share or (more likely, frankly) that the stock breaches $60 before April. Not a bad idea. I have to think about this more, though, so I’m not ready to commit.
The same goes for Research In Motion (NASDAQ:RIMM), trading now at $7 with buyout rumors on the table. March 7 Calls are going for $2.58. I think any buyout would be for more than $9 a share, but unlike Coinstar, I’m not as optimistic about the stock hitting that level on its own. This is a pure speculative play.
Electronic Arts (NASDAQ:EA) is very much in the same position, and it’s a purely speculative move to buy the March 13 Calls for $1.65. Cheap enough to make the speculative play attractive, but I’m not in a speculative mood at the moment.
Lawrence Meyers is long Coinstar, and has sold Sept 47.5 naked puts against the stock.