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Zynga, Inc. (ZNGA) has taken a beating as of late, and it certainly did not help that early in October the company announced preliminary results for the 3rd quarter, which looked terrible at best. The stock has shed over 21% since then and is down over 85% from its high of 15.91 in March. 3rd quarter results were released last Thursday, and the results as expected were horrible. However, there were some pleasant surprises. For example, sales topped forecasts. Sales for the quarter came in at $317 million, an increase of 3% year over year. Analysts polled at Thompson Reuters were predicting sales of $265 million. Zynga reported a net loss of $52 million, but if compensation costs were not factored in, it broke even and the results were in line with expectations.

It formed a partnership with U.K based gaming operator bwin.party. This a good move because it opens up another potentially lucrative stream of revenue for the company.

"We view this as a first step into real money gaming." Zynga CFO Dave Wehner said on the earnings call. "We believe it's a good first step, but only a first step towards what we think is a big opportunity for Zynga.

The stock is also trading below book value, which currently stands at $2.38. Finally, the company announced it was planning a $200 million stock buyback program. This is a favorable development because it reduces the number of outstanding shares and in the process increases the earnings per share.

From a technical perspective, the stock appears to found support in the $2.1-$2.21 ranges. It is also trading in the extremely oversold ranges, the percentage short of float stands at 12% and thus in our opinion it is ready to at least experience a strong relief rally.

When a stock is in such a position, it is usually a good time to sell a naked put, or initiate a Bull put spread. However, as the stock could suddenly surge upwards, we think a slight modification of the Bull put strategy could prove to be very useful. We are going to write a Bull put spread, but we will use the credit obtained from the spread to purchase calls. This provides us with limited downside risk, but with unlimited upside potential. If you are happy with just putting the Bull put strategy into play only, then you do not have to follow the last step which entails the purchasing of call options.

Benefits of a Bull Put Spread

1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).

2. The ability to profit even if the stock barely budges in price.

3. The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put on Electronic Arts (EA) with a strike at 12 and the stock dropped to zero, your loss would be $1200 minus the premium you received. Now if you purchased a put with strike at $10.00, your maximum loss would be $200 minus the net premium you received.

4. The capital requirements are significantly less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $200. This is significantly less than the $1200 you would have to put up if you sold cash secured puts at $12.00.

5. In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

Technical outlook

It is attempting to put a bottom right now and could test the $2.10-$2.16 ranges again before the bottoming process is over. It appears that the worst news is priced into the stock and the high short percentage of float (currently at 12.2%) makes it a good candidate for a short squeeze. As long as it does not close below $2.00 on a weekly basis, the outlook will remain neutral. A weekly close above $2.60 will be a bullish development and should push the stock to the $3.10-$3.50 ranges. If this comes to pass, we would close the entire position out.

Suggested strategy

We are first going to write a Bull put spread and then the proceeds from this spread are going to be used to purchase calls.

The March 2013, 2.00 puts are trading in the $0.23-$0.24 ranges. It should be relatively easy to sell these puts at $0.23 or better. For this example, we will assume that the puts can be sold for 23 cents or higher.

The March 2013, 1.50 puts are trading in the $0.07- $0.09 ranges. The spread is a bit wider here, but you should be able to buy the puts for $0.08 or better. After the transaction is complete, you will have a net credit of $15.00. If you are happy with just writing a Bull Put spread, you could stop here. Your total risk in this case will be $35.00, and your maximum gain will be $15.00 for a return of 42.9% in roughly four months.

The next step will entail using the proceeds from the above transaction to purchase calls on Zynga.

The goal here is not to put up any new money, so we are going to aim for calls that are selling at or below $0.15. If you are up to putting up a little extra money, you could aim for the March 2013, 3.00 calls. In this example, we are going to aim for the March 2013, 3.50 calls which are currently trading in the $0.11-$0.13 ranges. We will assume that the calls can be purchased at $0.12 or better. For each Bull put spread you write, you will be in a position to purchase one call and have a net credit of $3.00 left over.

Transaction Details

  1. After you write the Bull put spread and purchase the call you will have a net credit of $3.00
  2. Your maximum risk is $47.00 (the spread of $50 is subtracted from the credit of $3.00).
  3. Your maximum profit potential is unlimited due to the call purchased. Technically there is no limit as to how high the stock could rally.

Conclusion

This is a very volatile stock and at this point of the game we would also have to call it a speculative play. This strategy takes away a large portion of this risk because you know exactly how much you stand lose even before you put it into play. The call side of the strategy provides you with the ability to lock in unlimited gains should the stock take off. The Bull put spread limits your total risk to $47.00.

Do not abuse this strategy as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put will not prevent the shares from being put into your account. If you have over-leveraged your position, there is a way to deal with the problem. One option is to roll the short put the moment the stock trades at or slightly below the strike price you sold the put at. You would simply purchase the put you sold and sell new out of the money puts. Consider closing the position out if the options are showing gains in the 60%-100% ranges or if the stock trades to the $3.10-$3.50 ranges.

Options tables from yahoofinance.com. Option profit loss tables sourced from poweropt.com.

Source: Zynga: Low Risk, High Reward Strategy For This Speculative Play