CSCO Bet May Be Worth Coattailing!

  • July 13, 2001
  • Jon Najarian

I’m not saying that yesterday’s
action, impressive as it was, signaled a bottom has been put in, but I will
say for the record that there is more and more evidence that the smart money is
betting on just that. To wit:

As we reported yesterday to Kopin Tan at the Wall Street Journal, a LARGE
institutional trader sold 200,000 Cisco
(
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PowerRating) January 17 ½ calls yesterday. This
ranks as one of the largest equity option trades we’ve ever seen, but
shouldn’t be taken as bearishly as a naked sale of calls would be taken. In
fact, the trader (someone that routinely sells 100,000 puts in CSCO, or Sun
Micro
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when he sees a short-term bottom) was selling out of inventory and switching
over to direct participation by buying 7 million shares of Cisco

(
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PowerRating) stock.

All of that may be confusing, so let me simplify the transaction. The trader
already owned the January 17 ½ calls, perhaps because he wasn’t comfortable
owning the stock until the Motorola
(
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Yahoo
(
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PowerRating) and Microsoft

(
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PowerRating) news came out. By buying the 17 ½ calls, the trader defined his
risk upon entry and when that risk diminished, sold out the calls and went
long the stock. A pretty bullish move in any market and potentially, a
defining moment in this uncertain environment.

Here’s one way traders are coattailling that institutional trader with
substantially less risk: With Cisco trading for $18.76, they will buy 1000
shares and risk $18,760. Or they could buy 10 of the January 17 ½ calls for
$4.40 and sell 10 of the CSCO January 25 calls for $1.50. They’re total out of
pocket for a position that controls 1000 shares of CSCO between 17 ½ and 25
is a mere $2,900 ($4,400 – $1,500). That 7 1/2—point bull call spread is
intrinsically worth $1.26 since the underlying is trading for $18.76, so they’re only paying $1.64 in extrinsic premium.

Let’s look at what they’ve done:

They’ve defined their risk on entry
and used only 15% of the capital that a stock buyer would have had to pony up.

  • If CSCO finishes $20 on January expiration,
    their spread is worth $2,500.

  • If CSCO finishes at $22.5 on January expiration,
    their spread is
    worth $5,000.

  • If CSCO finishes at $25 on January expiration,
    their spread is
    worth $7,500.

A
close at $23.30 means a 100% return (less commissions), as their $2,900
investment would be worth $5,800. The bottom line is that they can take a lot
less risk and still participate in the stock market.