Short-Term Call Options: The Only Time to Use This Investment Strategy
by Karim Rahemtulla, Options Expert
Tuesday, August 10, 2010: Issue #1320
Okay, so let’s say you’re holding a big share position in a particular company, but you’re facing a dilemma.
For one, you’re not comfortable because of the way the market is acting. And second, you’re not sure how recent news may affect the company’s forward guidance.
As if that isn’t enough, few events can influence the short-term direction of share prices like earnings season…
That’s the situation that faced many Visa, Inc. (NYSE: V) shareholders a few weeks ago.
Let me show you how you can handle the earnings season conundrum…
Not Cash or Charge… Cash and Charge
A few weeks ago, Visa’s debit card business was in the government crosshairs. Specifically, the government was concerned that Visa was charging merchants too much for debit card processing.
Debit cards are like cash and Visa charges merchants a percentage of the transaction total on every debit payment it processes.
Visa hands the card’s issuing bank a big chunk of that transaction fee. And the retailer passes the fee on to the consumer as part of the product price.
In effect, you’re being charged for the convenience of using your own money.
So that’s the scenario…
Visa’s business was under the threat of government regulation just weeks before the company released earnings. And shareholders were sitting right in the crossfire.
The Only Time to Use Short-Term Options
When the legislation passed, Visa shares took a hit, but not a big one.
But the issue for shareholders was this: What would Visa say about its future earnings as a result of the new legislation? Would it guide lower? Would the news be priced in? Would the stock tank once investors heard the news?
Keep in mind that it would be nearly impossible for 99% of investors to figure out the impact of something like this without having direct knowledge of Visa’s fee structure or internal calculations.
So what would you have done?
To handle an unpredictable situation like this, it’s the only time that I advocate using short-term call options. But only with certain assumptions. For example…
- You can only use this strategy within days of the earnings release.
- You might give up a few percentage points worth of potential gains on your shares if the share price might move higher.
- You’re not expecting a catastrophic share price collapse, but with the price likely to move lower, you’ll protect your downside.
A Safety Net Trade with Short-Term Call Options
So in reality, here’s your safety net trade (please note that this is not a specific trade recommendation, just an example of how this strategy works)…
A couple of days before Visa issued its earnings, the share price was trading at $75. The downside wasn’t likely to be more than 10% to 20%. And the upside was also fairly limited, since the news wouldn’t be perceived as “great.”
- Look at the options with a strike price about 20% below the trading price. In this case, the closest would be the $65 call options.
- Sell the August $65 calls, trading at $10.50 against your share position. In doing so, you’d receive $10.50 per share, thus reducing your cost to $64.50 ($75 minus $10.50).
- Your upside would be limited to $75.50 ($65 strike price plus the $10.50 premium received).
If Visa shares moved lower: You’d be covered since the options premium received would offset the decline in share price.
If Visa shares moved higher: You’d be obligated to sell the shares at $75.
In this case, Visa dropped by $3, so you’d have lost nothing. You could simply buy back the option and maintain control of the shares.
When you have a lot of money at risk, it’s prudent to do more than just “hope” that things will work out fine. And with options, you can do just that.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
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- How to Sell Put Options and Snag the Market’s Daily Deals
- The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
- Embracing Volatility… How to Use the Put-Sell Strategy to Grab Stock Discounts and Cash
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
9 Responses to “Short-Term Call Options: The Only Time to Use This Investment Strategy”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
I trade options fairly frequently, especially covered calls and naked puts, and I don’t really understand Karim’s strategy in the above example. He is basically locking into selling Visa at a net price of $75.50 after option exercise when the current price is $75. Why would anyone even bother selling an option for only a $.50 premium on a $75 stock? In this example, the stockholder should have just sold Visa at $75 outright and not worried about the option. He is giving up a maximum of $.50 profit per share, but gets access to the cash immediately and does not run the risk that the stock price would fall below $65.
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Jeff,
The reason for doing it in such a way is that it actually allows the option seller to profit if the shares move lower and don’t collapse, as they did with Visa. The option can be bought back for less, locking in a profit on the option, and if the guidance is not as bad as it could have been, then owning the stock is still a viable alternative and it will then recover or go higher.
But, there is always that chance that it could tank and so you have to watch your back. In Visa’s case, the price did dip to the low $70s and has since recovered.
Thank you for your comment,
Investment U
Reply
Very interesting and useful strategy when trying to protect against earnings surprises.
I do have a question, however. If the strike price of the call option is $65.00 and the shares move higher, why would we be obligated to sell the shares at $75.00? Would we not be obligated to sell the shares at $65.00 by options expiration?
Thanks
Reply
Larry,
Yes, you are obligated to sell at $65, the strike price, but since you took in $10.50, your effective sell price was $75.50.
Thank you,
Investment U
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Take a look at weekly options. I’ve doubled my money many times in less than an hour.Option trading is not as complicated as most would try to make us believe. Direction, in the short term, is many times more important than volatility and time decay.
Peter Schumacher
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I’ve had good luck with the weeklies, too. I’ve doubled my money many times in less than an hour.
Peter, what are you trading? Weeklies on FAS? Just a pure short-term directional bet (not held overnight)?
Curious…
MikeS
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You want to keep your stock, so why not buy short-term puts to protect the downside?
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I agree with all you have suggested, but does the decision go deeper than just the price. Would you not wish to consider the tax consequense. The option money would be at ordinary gains, and your basis on the Stock would be definate consideration.
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Your strategy WAS initially stated incorrectly as question 2 above indicated. In addition, these days the risk is high that the stock will go UP and the option price will increase which means you will lose money if you buy it back and you’ve also given up your profit that you would have gained had you done nothing.
Wouldn’t it make just as much sense to sell an out of the money option to gain some premium which would still allow you to profit from a stock price increase but also let you buy back the option at a lower price if the stock price decreased? Or, sell an out of the money put to generate some cash to cover the possible price decrease?
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