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Sirius Investors Hedge With Upside Calls

As the CEO prepares to sell a huge chunk of his stake, short-term call options become popular


Sirius XM (NASDAQ:SIRI) — home of Howard Stern, the NFL, and other tours de force — has been in recovery mode in 2012, gaining almost 27% and encroaching on its 52-week high set last May.

This move comes despite the announcement that CEO Mel Karmazin is hoping to unload a chunk of his holdings in the satellite radio outfit (to be better positioned for “philanthropic efforts,” he says).

While Karmazin’s move doesn’t seem to have anything to do with his outlook for the shares, it could have a short-term impact on SIRI as he exercises 60 million of his options.

SIRI investors concerned about a pullback in the shares may be responding via a covered-call strategy. Option activity was notable in SIRI shares on Friday, with 46,000 calls and just 2,000 puts changing hands to outpace average option volume by more than two times. (Stock volume was also heavy, as 97 million shares traded, versus average daily stock volume of 46 million shares).

The March and April 2.5 call strikes were among the most-active options trading on Friday, with the majority of the activity trading off the bid price (suggesting the trades were initiated by sellers). It appears as though some of the volume was being sold to open, as open interest increased at both strikes this morning. Additionally, some investors may have been selling out of existing long calls.

In the covered-call strategy, the investor collects a premium for selling calls in exchange for assuming the obligation to buy shares of SIRI at the strike price at or ahead of expiration. What makes the calls “covered” is the existing stock position that is available in case the trader has to fulfill this obligation. Typically, out-of-the-money calls are employed for this purpose.

Speaking hypothetically, if the April 2.5 calls were sold for nine cents each, the investor would collect this credit at the outset of the trade. If SIRI is still trading below the 2.5 strike when the options expire, the calls expire worthless and the call seller keeps this credit as profit. If SIRI moves higher, the call buyer on the other side of the trade will likely exercise his right to buy the shares at this price. As previously mentioned, the call seller has these shares readily available but then surrenders any upside in the stock above the strike price.

Now, if SIRI shares move lower once the covered call is executed, the trader will participate in any stock losses, but these will be offset by the credit earned from selling the calls. Nine cents may not seem like much, but it’s a lot more significant when the stock is  trading at only $2.31 (almost 4% of the stock price).

The most the covered call can lose, in the event that the underlying shares drop all the way to zero before the calls expire, is the stock price at the time of the trade less the call premium.

A covered call’s maximum profit is the premium plus any upside in the stock through the strike price. For example, if the call were sold for nine cents with SIRI at $2.29, the maximum profit would be 30 cents, or the credit plus the difference between $2.50 and $2.29. Again, this might not seem like a lot, but it’s a 13% return in this popular low-priced stock.

As of this writing, Beth Gaston Moon does not own any shares mentioned here.

Article printed from InvestorPlace Media,

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