It helped with the discussion,
Actually I should have posted his rewrite, where he explains parts that may have been unclear. (Regular text is from the original column, bold is the rewrite text.)
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thestreet.com
Cramer's Rewrite of His Column on the Options Firefight over Intel
By James J. Cramer
7/18/98 9:39 AM ET
This column is an explanatory rewrite of Jim Cramer's July 15 column titled The Options Firefight Over Intel.
* * * * *
Now that Intel (INTC:Nasdaq) reported the in-line number everybody was looking for, the real battle begins. (Wow, who would have thought this was a controversial statement? Intel has become such a battleground that nobody even believes the real number, let alone the whisper number or the guidance.
But one thing was certain: The stock did go up. And it did not go up because the number was worse than expected. Can we please stipulate that Intel took an inventory writedown that fooled everybody, including TheStreet.com, with the only exception between the rest of the Fourth Estate and us being that we admitted we blew it?)
No, not the battle between the bearish Kurlaks from Merrill and the bullish Edelstones from Morgan Stanley Dean Witter. Everybody knows that battle. (This was an allusion to the ongoing tug-of-war between people who think Intel is too high, led right now by Tom Kurlak, a titan analyst at Merrill, and the people who think Intel is too low, led by Mark Edelstone, an incredibly hard-working, non-promotional analyst from Morgan Stanley.)
I'm talking about the conflict between those who hope that Intel goes out at 80 and those who bet that the gravitational pull of the strike price won't be strong enough to keep the stock down in the face of potential upgrades. (Promotion drives stocks. When an analyst goes from hold-to-buy or from a two-to-a-one, that creates a buzz among the firm's salespeople. They make a call to their clients on Intel that gets them excited. Here is a stock, that while up from $65, is still way down from its high, at a time when the Nasdaq is hitting an all-time high. That gets people buying. That's why we at Cramer, Berkowitz focus so heavily on upgrades and downgrades.)
(The strike price reference has to do with options. Options are set at certain round numbers. Here the Intel July 80 call represented the option with the most activity.)
This is not a piece about Pentium 6 yields. It is not a piece about chip inventories, or gross margins for that matter. (Were it a piece about these things, it would be saying that inventories were just okay, but getting better, and gross margins were just okay with a hope of getting better. Why do we care about inventories? Because inventories are the raw basis of supply and demand that controls price.
If Intel is overinventoried it has to sell product at low prices. If it is undersupplied, that means demand may be outstripping supply and it can raise price or keep pricing high. That affects Intel's gross margins, which, in the end, determine its profitability.)
It is a piece about a little-known war that goes on every quarter, the war between those who have speculated on Intel with near-term calls (July 80s, as I have), and those who feel that Intel can be "pinned" to the strike by expiration pressures. (A word before we get involved in this, which represents on a one-to-ten scale a degree of difficulty of about nine. One reader e-mailed me this week and said that his options broker thought the whole premise of this piece was false and that this battle doesn't happen.
To which I say, I have the battlefield medals and scars to prove it did and that his broker is simply out-of-the-loop. That's entirely possible; I had been in the business five years before I figured that these battles went on, and it took me another five years to figure out how to win them!)
Let's back up a bit. First, I have no desire to write about my interpretation of the conference call or the quarter. If you were on it, your opinion is as good as mine. If you weren't, your broker's opinion, melded with your newspaper and Web accounts, is as good as mine. (This bit of analysis was wrong! But let me tell you how I arrived at it. I don't sit around and read the reporters' stories about conference calls and earnings. Heck, sometimes those are right and sometimes those are wrong.
We have internal models showing what we think Intel should earn given certain unit shipments and pricing. We then match them with what Intel did earn and we listen to the conference call to try to figure out both the differences between what we thought would happen and what did happen, and what the guidance for earnings will be going forward.
It turns out that a bunch of people did not know anything about the way companies account for earnings, or they would never have said that the quarter was missed. There was a second set of people who thought that Intel just made this charge up and the quarter was light, but that makes no sense. And then there was a third group who thought, who is Intel to try to predict a turn?
Herb Greenberg was one of those, and he mentioned me as someone who might be wrong in taking Intel's word for it. Sure I might be; sure Intel might be. But the Herbster missed the key issue: Intel had been downbeat for several quarters; the change in inflection mattered as the company had earned the right to be more positive if it wanted to be.
In other words, these guys are not Pollyanna's. They know that there are cycles. My experience with Intel is that sometimes its people know that its down cycle is ending and sometimes they think it isn't. Anybody on that call would get the impression that it is ending. That impression is what mattered for the next five points up.)
What I want to open your eyes to is a silent, bloodless campaign to keep Intel at the strike or let it expand beyond 80. In the hedge fund world I live in, there are two ways to speculate on a stock: the common and the options. If you thought Intel was going to generate an upside surprise or might garner a few upgrades after the quarter, you might want to buy the common stock. But how about if you were worried that there will be a shortfall? Why not buy the call instead? In this particular case, the July calls gave you the flexibility to capture the upside generated by the earnings report. (Intel reported Tuesday; the calls don't expire until Friday.)
(Here is the guts of the piece. I try to find ways to limit my risk at all times, including ways that involve options. Let me first give you an obvious unrelated example. When Cendant (CD:NYSE) broke the news that it had accounting problems, the stock was at $37. Let's say I had been long the April 30 call for $7.5, a probable price for an instrument that deep, when Cosmo (the cfo) hit the fan.
I would lose all of my option value as the stock cascaded to $16, but I would not lose the attendant $14 that I would have been gaffed for had I owned the common.
Of course, I, like Walter Forbes, the chairman of the company, had no idea that the fraud was going to occur, so I didn't think to own calls. That cost me a bundle.
Now let's cut to Intel at $80.75, where it was the day before it reported. The chipmaker's stock had just run from $65 to $85. If the company were to report a shortfall of mammoth proportions, it is reasonable to believe that it could be hit down to at least $70. If the quarter were finessed or the outlook uncertain it might drop $6 to $75.
What are my options here? I could, a. buy the stock and take the risk; b. buy the stock and buy puts underneath it to protect myself in the event of a shortfall; c. buy the deep-in-the-money calls for $6.375 -- the ones that allow you to have all the appreciation above $75 but none of the loss below it; or d. buy the July 80 calls for $1.675, allowing me to capture any appreciation above $81.675 -- the $80 strike price plus the $1.675 price of the call.
I thought the latter approach offered the best risk/reward. As everything in this business is risk/reward that was the option I picked.)
The problem with the call, of course, is that it is a zero-sum game. (I regretted this Thurow-speak right after I filed this piece. What I meant here is that there is a winner and a loser and the winner takes all and the loser gets none.) The guy who sold you the call wants that call to go out worthless. That's how he wins. You win by having the stock explode past the strike, hopefully far enough to make some serious bucks. (Here is the tension. When someone sells you a call, he can sell it to you "long" or sell it to you "short." The guy who sells it to you long is selling it "to close," and getting rid of the position. The guy who is selling it to you short, is a guy who may be, a. long the stock "underneath"; or b. short "naked."
The guy who sells it long to close is not at issue here. He is not relevant to the battle. The guy who sells it to you with the common underneath has basically made a sell decision; he is willing to "lose" the stock or have it "called away," with the stock "in- the-money," or above the $80 strike. It's the naked short-seller that you, as someone betting on a move up, has to worry about.
Let's say he sells the call to you naked for $1.625. He would like to see the stock go out as close to $80 or below $80. Why? Because if the stock goes out below $80 on the third Friday of the month that call is "worthless" and will not be exercised. That's the homerun.
So, let's go through this slowly. You sell 100 calls for $1.625. That means you are selling the right to own 10,000 shares of Intel common stock ABOVE $80. No one wants the right to own a stock above $80 if it is at, say, $79. The person who bought your call paid you $16,250 for that right. (100 calls at $1.625 with each call representing the right to 100 shares, ten calls equal to 1000 shares and 100 calls equal to 10,000 shares.)
But how about if the stock closes at $81? Your call, which you sold at $1.625, is still worth a dollar and would be exercised -- and the owner of the call would take in his new stock -- meaning that you would be called upon to supply 10,000 shares of Intel by your broker.
But we have already established that you did not own the stock. You are short the call naked. That means that unless you had the ability to buy the call back before the close at some price, you would have to go into the open market on Monday morning and buy Intel's stock.
Or you could set up a short position of the common stock. Suddenly instead of being short this little call, you are short a ton of stock. You may be unhappy with that and scramble to cover. More likely, you would have just bought the call back Friday afternoon, and made the difference (sold for a $1.625, bought back for a buck, making $6,250).
Now let's make it really difficult, notching the calculations and skill up a bit. How about the following situation? How about if the stock goes out at $80.25? Or $80.125? If you owned that call would you exercise? Maybe, but maybe not. Maybe you don't have the capital to take in 10,000 shares of Intel at $80; maybe you are more of a small retail investor? You might just as soon let that call go out worthless.
For the short-seller that is nirvana. He sold you something that ended up worthless. How do you know whether the call is exercised? You don't. Over the weekend there is a giant options pool held, and some of your calls are exercised and some of them are not, depending upon how many people chose to exercise. On Sunday night your brokerage house knows how many were called away. Sometimes as much as 100% of your calls are wiped out, but sometimes it is only 90%. As the stock inches higher, the number called away gets lower.
Now, how about if the stock goes out at $80.375? I know this will stun you, but probably only 70% of the people will exercise that call. So, you could buy it back at the close, or you could try your hand at the random pool. You have what we call "found money" when you walk in on Monday and people who didn't have the capital to exercise their calls -- despite their closing in-the-money -- let them go worthless, even though they were worth something.
This situation happens constantly. And tons of money can be made doing this risky game of shorting calls betting the stock goes out at the strike.)
Right now, as a call holder, I am very worried that there was not enough "juice" in the quarterly release or the conference call that can get this stock to break out from the strike pinning that I know will be attempted by all of those who are short the calls. The call shorts can do this by "laying" on the stock and continuing to bang the call down, making the stock look heavy and thereby discouraging buyers. It is all perfectly legal and perfectly beleaguering. It has a massively sour yet unseen impact on the stock price. (Many people were skeptical about shorts leaning on stocks, but when you think of it, hey, there is a lot of money on the line if you can get that stock to go out at $80 when you have sold a call, so if you can spook it down by indicating that you have a lot of stock for sale to market-makers or by perpetually hammering the call, you can cause any stock, but particularly Intel, to go down. This does occur and we should not be naive about it.)
But if Intel gets some upgrades and a head of steam, the call sellers can't work their dark magic and the stock will break out. That is the short-term battle that will determine the next three points in this stock. (Sometimes it is not just the shorts who help the stock stay pinned, though. Those who were disappointed in the quarter naturally would sell. Others who were speculating on a blowout and felt unrewarded would also hit the bid. These forces can naturally coalesce to create pressure.)
May the best man win.
Of course, maybe Intel doesn't go up at all. Maybe it goes down. In some ways, that is a push for the call holder -- I won't lose any money below 80 -- and a home run for the call seller, who doesn't ever have to cover, as the call may go out worthless. (Intel went up; I made money.)
For long-term holders, this column represents gibberish, the inside baseball account of what will really dominate the trading in this chip maker for the next 72 hours.
But for short-term traders, it's the shooting match. (Remember my job as a columnist is to try to explain movements in stocks, the anatomy of gains and losses. Sometimes the moves are short-term right long-term wrong. But at all times there are reasons for what happens.
Many times we know the reasons; sometimes there are reasons but they are not obvious. This column is about a less obvious tug on a stock.)
I play both roles. I believe that barring unforeseen market downturns, this stock could trend higher. That's why I am long it. If it can't escape the gravitational pull of the strike this week, maybe the upside will be manifested next week, when there is no option-induced pressure.
(It is the expiration, and the hundreds of thousands of decisions about whether to take in stock or lose it that causes this short-term gyration. It is a gun to the head and it creates selling pressure.)
In the meantime, at least I know why the stock may not react as well as I would expect it to otherwise. I know this, because I have seen this pattern so many times in my trading life, particularly with Intel, that I have to factor in the options activity to get an accurate read about what is occurring in the common. (Again, I have both sold calls short and long and am familiar with the battles in the pits. Those who think they don't exist simply haven't been there.)
I know this analysis may be a tad confusing to all but the option aficionados out there. That's okay. On Saturday, I will pull this piece apart in my Take Two, something that I didn't get a chance to do while on vacation.
In the meantime, keep an eye on the options. They hold the key for now. (Traders were heartened by the call, institutions bought more, Andy Neff, an influential Bear Stearns analyst upgraded the stock and the buying pressure broke the strike's chokehold. And the stock ramped five, and then settled back a bit, but had an excellent run.)
Still confused? Check the options school; I have written about these situations before many times and other pieces might help you get the hang of it. |
