Profiting On A Stock When You're Late To The Party - Using A Call Spread With A Naked Leg

Sep.18.12 | About: Cummins Inc. (CMI)

We've all been there before. You find a stock that interests you. You put it on your watch list. You do your homework. You choose an entry point and make a limit order.

You then watch in disappointment as your limit is missed and the stock surges forward.

I recently experienced this with Cummins Inc. (NYSE:CMI). As you know, this stock was pummeled in 2012. Showing promise at the beginning of the year, the stock then went on to shed over 30% of its market cap. This was consistent with other parts-makers and industrials levered to China.

In July, I took interest in the stock. Despite the weakness in China and emerging markets, I wished to enter a position due to valuation and also due to the fact that I believed the sector to be at a bottom.

Towards the end of July, I placed an order at the limit price of $90.00. The stock dipped to $90.48 and then surged upwards, some 17%. Have I missed the party? Not necessarily.

This morning I placed some options trades including a call spread and a short put. Here's how I did it.

  1. I purchased the January $110 calls (@ $4.40)
  2. I sold the higher strike January $125 calls (@ $0.90)
  3. I also sold a January $90 put (@ 3.60)

As you see, I received a net credit of $0.10 per contract; more than enough to cover commissions.

Essentially I am on a free roll; if the stock trades in a range of 90 to 110 for the next 4 months, I walk away from the trades. If, however, the stock continues to rise as hedge funds rotate into the sector (as some have observed) then it's all profit up until $125, where my gains are capped.

On the low end, so long as my interest in entering the position at $90 remains, I have no inherent additional downside risk.

This is a strategy which I am considering employing for Ross Stores (NASDAQ:ROST) or (NYSE:CRM). You might even consider it for Facebook (NASDAQ:FB); however, I'm not going to do that.

In Conclusion

The risk/reward analysis must be driven first by a well researched entry point for the stock. This represents your only risk, and if you have done your homework, there is no additional risk.

Disclosure: I am long CMI. I have positions as discussed in the article. I also may initiate similar positions in CRM and ROST in the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.