You're sure a favorite stock is going to surprise to the upside with tonight's earnings report. You buy calls and write puts, short maturity, at the money, creating a synthetic long position. Earnings do exceed expectations; the next day your calls spike up and the puts are nearly worthless. Now what?
You could sell the calls and buy in the puts, stash your profit in the kitty and go on to the next trade. Or you can gamble further and let either or both sides ride to expiration, assuming you're prepared to own the stock. But what if you still like the stock and you'd like to build a longer term position without investing more capital?
I've been experimenting with a technique shamelessly stolen from the dividend growth crowd. It's a variant of DRIP, dividend reinvestment program. Let's call it PRIUS for "profit (or premium) reinvestment into underlying shares." Or perhaps a commenter can come up with an acronym that won't get me sued by Toyota.
Here are a couple of trades I made this earnings season using this technique. Before EOG Resources (NYSE:EOG) reported Monday, May 6, with the stock at about 126, I bought two May 125 calls for $4.12, and sold one May 130 put for $6.49 and one May 125 put for $3.45, netting me about $160 after commissions. When I use this technique, I like to put the position on for a net credit; hence selling the 130 put instead of another 125. Sure enough, earnings were good and the stock gapped up on the 7th to the mid-130s. A nice profit in hand, I started taking something off the table. On the 7th I bought back the two puts and sold one call for a net of about $970. I might well have just left the cheaper short out there and saved 34 bucks; I gave up a bit of profit to avoid eight days of risk that EOG would drop below 125. If you play this method using weekly options, which EOG does not have, it's easier to stay short the out-of the money puts through expiration.
Now I'm ahead $1,130 and own one free call worth about a thousand dollars. I still like EOG, but don't want to pony up $12,500 to own 100 shares. (If these small numbers are boring anyone, feel free to imagine the trade using 100 contracts, or a thousand.) What I'd really like to do is invest my profit in EOG. I held my position until the 9th, by which time EOG had drifted a bit further up, to 136 and change. I sold the option at $11.50, and bought 15 shares at $136.42. Now I've converted my option profit to stock and have about a hundred bucks left over. Note that I was able to get a few cents time premium out of my six-days-to-expiration option; this is not always possible close to expiration, and you may find that you can't even get intrinsic value by selling the call, depending on the bid/ask spread. If that happens, you can just short the underlying (here, I would have shorted 85 shares) and let your call get assigned at expiration, leaving you long the desired shares. In this case, of course, you must watch the underlying and make sure it doesn't slip under the call strike at expiration, leaving you with an unwanted short over the weekend.
Marsh and McLennan (NYSE:MMC)
Trade date 04/26/2013. Bought 3 MMC May 38 call, sold 3 May 38 puts for a net credit of about $108. On 5/3 sold 2 calls and bought back all three puts for net credit of about $130. On 5/14, sold the last call and bought five shares of MMC for a net credit of about seven dollars, ending up with the five shares and about $246 as profit.
This method gets interesting as you repeat the exercise with the same stock, particularly if it has weeklies. If the stock stays in an uptrend, you accumulate shares every option expiration. If it doesn't move, you lose nothing. If the stock drops, you can sell your accumulated share profits to offset the options loss.
A good question is: why this technique instead of buying the stock, then selling enough shares to recover your investment after the stock rises? Certainly, the transaction costs are higher using options. A few reasons to consider the options approach come to mind. If you're nimble, you can sometimes pick up a few cents per share if the time premiums between the puts and calls get unbalanced. I find that being in options, an inherently short term proposition, makes me less vulnerable to "it went down, I'll just hold until it bounces back" psychology. You're playing for a short term bounce in the stock and keeping that in mind is key. Most importantly, if your account has available margin but no free cash, the artificial long is a way to utilize margin without incurring margin interest.
Caveats: As with any strategy, you have to be brutal in cutting off losers. This is an effort-intensive technique, requiring much monitoring (some of which can be alleviated through the use of stops and conditional orders, perhaps). Accumulated transaction costs will eat into profits (another reason I like to start with a credit). Be aware of ex dividend dates and use them to enhance or protect your profit - you don't want to be locking in your share count by shorting the day before the ex date.
In this day of discount brokers and easy trading in odd lots, the options DRIP can be a way to gather up shares - provided you know which way the underlying is going to move. It's just that easy.
Disclosure: I am long EOG, MMC. 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.
Additional disclosure: Dammit Jim, I'm a lawyer, not an investment adviser. This article is not a recommendation that anyone buy or sell, or do or not do, anything.