Bullish On Cognziant Technology Solutions

May.11.12 | About: Cognizant Technology (CTSH)

In a previous article related to Cognizant Technology Solutions (NASDAQ:CTSH) posted on April 19, 2012, a protected covered call was considered for the company. A protected covered call may be entered by selling a call option against a stock and using some of the proceeds from selling the call option to purchase a put option for protection. The protected covered call provides a position with the potential to generate a return even if the price of the stock remains stagnant, yet also provides protection in case the stock price takes a hit.

In the company's Q1 2012 earnings call held on May 7, 2012, CEO Francisco D'Souza, indicated the company was revising its 2012 guidance lower, and as a result, the company's stock price took a hit as shown below:

Cognizant's stock price is now down -16% from the posting of the previous article, but the protected covered call position is only down -7.6%. A loss of -7.6% is much easier to recover than a loss of -16%.

The reason the company revised guidance lower was due to not seeing strong acceleration in growth from Q1 to April as is typically the case.

Since Cognizant's haircut appears to be overdone, its earnings release is in the rear-view mirror and its stock price is not too far off of its previous support level of $55, closing the protected covered call and entering a bull-put credit spread will be considered for the company. A bull-put credit spread may be entered for a credit by selling one put option and purchasing a second put option further out-of-the-money. The goal is for the options to expire worthless at expiration and to keep the initial net credit as profit.

Using PowerOptions tools, a bull-put credit spread for Cognizant was found with a potential return of 10.1% (102.7% annualized) as shown below:

(Click to enlarge)

The specific put option to sell is the 2012 Jun 55 at $0.68 and the put option to purchase is the 2012 Jun 50 at $0.22. A profit/loss graph for one contract of the bull-put credit spread is shown below:

For the position from the previous article, the Cognizant stock can be closed for $61.05, the call option can be closed for $0.05 and the put option can be closed for $4.00.

The aggregate potential return when considering the previous position and the new position is 2.5% (10.1%-7.6%). So entering the bull-put credit spread provides a position which not only recovers the loss from the protected covered call, but also provides for realizing a potential profit. However, the bull-put credit spread is highly leveraged and much more risky than the protected covered call, so care should be given to monitoring the position for management.

A management point for the Cognizant bull-put credit spread is set for $57.50. If the price of the stock drops below $57.50, then consideration for managing the position for an exit or a roll should be given.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.