In my last column, Bearish Options Strategies, I discussed ways in which long-term, value-oriented investors like me might use put options to make bearish bets, either to make money or hedge (or both). Today, I'd like to look at the opposite of put options: call options, which represent the right (but not the obligation) to purchase the underlying security at a certain price (the strike price) within a certain period of time (before the expiration date). While I'm generally not a fan of options, in certain situations call options -- used sparingly -- can be a sensible investment. Allow me to describe four such situations in which I've used, or considered using, call options.
Short on cash
Great investment ideas were a dime a dozen last spring, yet I held only 15% cash, vs. 29% today. I wanted to make large investments in really cheap stocks like Office Depot (NYSE:ODP), Yum! Brands (NYSE:YUM), Home Depot (NYSE:HD), and McDonald's (NYSE:MCD), but I didn't want to sell any of my existing holdings, which were already cheap. Nor do I ever recommend using margin.
Taking McDonald's as a case study, I had started purchasing the stock in Dec. 2002 and Jan. 2003 around $16, yet by early February the stock was at $14. At that time I was unhappy about the losses on my investment to date, but also thrilled at the opportunity to buy the stock at an even greater discount to intrinsic value. Yet I was short on cash, so I instead looked at call options.
Which to buy? I wasn't interested in short-term options since it can take a long time to turn around a company, especially one as large as McDonald's, so I turned to LEAPS (Long-term Equity AnticiPation Securities), which are simply long-dated call options. The longest-dated ones, available in early 2003, expired nearly two years hence in Jan. 2005, which I thought was enough time for my investment thesis to play out.
Then I had to decide on a strike price. There's no simple answer here: The higher the strike price, the less money one has to invest and the higher the percentage return if the stock does well. But -- and this is a big but -- there's also a higher risk that the option expires worthless. Being a conservative investor, I decided to buy LEAPS with a $10 strike (meaning they were $4 in the money), and paid $5.70. Assuming I held to expiration -- which is how I usually think about options, as it's most conservative -- this means that the stock would have to rise 12% from $14 to $15.70 ($10 strike plus the $5.70 I paid for the option) for me to break even on this investment. As the stock rose above this, the percentage returns would grow quickly.
At the time, I estimated that McDonald's was conservatively worth $25 per share, so I thought it was highly likely that the stock would rise far more than 12% over the next two years. I also felt that there was little risk the stock would fall, given McDonald's valuable real estate assets and strong brand and cash flows.
To make a long story short, CEO Jim Cantalupo has led a remarkably quick, robust turnaround (for which I nominated him as 2003 CEO of the Year), and the stock has more than doubled, closing yesterday at $28.84. The options are now way in the money, so they trade pretty much in line with the stock, meaning the LEAPS I bought are priced at $19 ($28.84 stock price minus the $10 strike price plus a tiny bit of time value). I've made 233% on the options, whereas I would have made "only" 106% had I bought the stock at $14 instead.
Keep in mind that this is a best-case scenario, however. Shortly after buying the LEAPS, McDonald's stock hit $12.12 and my investment had plunged in value far more than the stock. In other words, the leverage works in both directions.
A safe 80-cent dollar
Another situation in which one might buy call options is if a stock is only moderately undervalued, but it's a stable, steadily growing business whose intrinsic value is highly likely to grow at decent rate (say, 10%). In this case, the expected return on the stock might not justify buying it, but call options might provide enough upside.
Take Yum! Brands last Feb. 13th: the stock was at $22.73, which was 12.5 times trailing earnings and 11.4 times 2003 estimates. I estimated that it was worth at least $30 per share, meaning it was trading at a 24% discount to intrinsic value. I will almost never buy a 76-cent dollar -- I prefer to be patient and wait until I'm trembling with greed -- but given Yum's strong management, cash-cow domestic business, and excellent growth prospects overseas, I felt that it was highly likely that the company could hit its target of growing earnings per share at a minimum of 10% annually for the next few years.
So, I looked at the LEAPS. Like McDonald's, I found that Jan. 2005 in-the-money (in this case, $20 strike) calls were quite cheap: $6.20, meaning the stock only had to rise 15% over the next two years for me to break even (assuming I held to expiration). Given that I expected earnings to grow at least 21% (10% for two years) and that I felt the P/E multiple was far more likely to expand than contract, the risk-reward calculation for the LEAPS seemed very attractive, so I bought them. Like McDonald's, this investment has been a home run. The stock is now at $38.10 and the calls are worth $18.20, a 194% gain vs. 68% for the stock.
As for an investment like this today, you might want to take a look at LabCorp (NYSE:LH), a recommendation of one of my Buffettesque Superinvestor friends. In my recent column, Top Picks From Money Managers, he recommended the stock, saying: "With a recent enterprise value of around $6.5 billion, LabCorp trades at about 15 times estimated 2003 free cash flow -- a reasonable price for a business that combines high profitability, stability, and excellent long-term growth prospects. I own both the stock and the January '06 calls, which are very cheap."
In a recent follow-up email to me, he wrote: "Yes, we still love Lab Corp. We especially like the Jan '06 $20 and $30 LEAPS because of the leverage, and the fact that there is little time premium at the current quotes. The stock is at $39.19 and the $20 and $30 in-the-money '06 calls go for $21.10 and $13.30, respectively. So for the $30 LEAPS, for example, you get 3-to-1 leverage (by investing only $13.30 vs. $39.19) with two years of time value for only $4.11 in time premium." (That's the $30 strike plus $13.30 for the call, minus the $39.19 stock price, which equals $4.11.)
Bipolar outcome
Call options can also be an effective tool if a stock is likely to have a bipolar outcome -- in other words, it's likely to either skyrocket or plunge. A good example would be a small, single-product drug-development company that could be worth billions if the drug gets FDA approval and becomes a blockbuster, but nothing if the drug flops. Given that there's a material chance of losing all or a significant part of your investment, you would definitely want to make this a small investment. Assuming you feel that the drug will be a winner, however (otherwise, why would you invest at all?), you might want to buy a call option to maximize the percentage return on what might only be an investment of 1% of your portfolio.
For example, let's say you believe that Imclone System's (NASDAQ:IMCL) primary drug, Erbitux, just might be an enormous winner. You also recognize that the stock is extremely richly valued right now, so there's lots of downside if the drug fizzles (or investors simply lose their infatuation with speculative companies). Rather than paying $46.40 for the stock, you could invest 91% less capital by instead buying January '05 out-of-the-money $60 call options for $4.10. This would be an extremely speculative bet, as the stock would have to rise 38.1% -- from $46.40 to $64.10 ($60 plus $4.10) -- in less than a year to merely break even, so I would never recommend this investment (I was short Imclone for a brief period last year, in fact). Forced to choose, however, I would rather only risk 1/11th as much money buying the calls than the stock.
Hedging shorts
Buying a far-out-of-the-money call can be a good way to hedge a short position. Using Imclone again as an example, let's say that I was short the stock but wanted to protect myself against the unlimited potential losses if I'm wrong about Erbitux (or perhaps investors' ability to insanely overprice certain stocks). By shorting the stock, I can make up to $46.40 per share -- if the stock goes to zero -- yet by paying only $4.10 per share I can cap my maximum losses (until the option expires next January) at $13.60 (the $60 strike price of the call minus the share price of $46.40). I would only suggest considering this strategy if you believe there's likely to be a bipolar outcome -- and soon.
Conclusion
Before rushing out to buy call options, allow me to repeat the warning from my last column: As a general rule, I do not recommend options. They're illiquid, the bid-ask spreads are murderous, and it's always dangerous to have time working against you. It's hard enough to be right on the direction of a stock's movement, much less being right on the timing as well.
Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned stock and calls on McDonald's and Home Depot, calls on Yum! Brands, and was short the iShares Nasdaq Biotech Fund (IBB) at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.
