Stock Options To The Rescue! Cisco Systems (CSCO)

| May 17, 2012 | 0 Comments

CSCO OptionsToday we’re going to look at a stock replacement strategy on Cisco Systems.  It allows you to reduce your risk and gives you upside potential.

Here’s what happened…

Cisco Systems (CSCO) shares are down more than 11% after reporting earnings last week.  The stock has fallen from $18.78 to under $17 per share.  In the latest quarter, CSCO met expectations for quarterly revenue growth, beat estimates for earnings growth, but issued an ugly forecast for the current quarter.

Here’s the deal…

The tech giant reported quarterly earnings of $0.48 per share.  GAAP earnings were up 21% from last year and $0.01 per share better than expected.

The strong results were driven by a 6.6% increase in sales.  Revenue of $11.59 billion was in line with analyst estimates for $11.58 billion.

The solid earnings report was offset by a weak forecast for future revenue and earnings.

Here’s the kicker…

CSCO had a so-so quarter.  It wasn’t great but it wasn’t anything that sent up warning signs either.  But when CSCO’s CEO, John Chambers, started talking about his expectations for the current quarter, the warning bells began to ring.

Investors were expecting revenue growth of 7% during the current quarter.  But Cisco warned revenue growth would likely slow to 2% to 5%.

And EPS took a hit as well.  Analysts were expecting them to earn 49 cents per share this quarter.  But CSCO expects EPS to come in between 44 cents and 46 cents per share.

The reason for the shortfall is the economic uncertainty created by debt crisis and slowing growth in Europe.  Chambers said CSCO’s customers are taking a wait and see attitude toward tech spending until they see how things shake out in Europe.

Obviously, slashing future revenue and earnings estimates is going to drag down any stock.  And CSCO was no exception.

Anyone who bought CSCO prior to earnings is now sitting on some sizeable losses.  Instead of holding onto the stock for a rebound, consider using options to replace your stock.

Here’s what to do now…

Let’s assume you bought 100 shares of CSCO at $19 before earnings.  You’re sitting on a 12% loss.

Selling CSCO and buying the CSCO October $19 call option for $0.48 will reduce your risk and give you upside potential if CSCO rebounds later this year.

Let’s take a closer look…

At the recent price of $16.69, you can sell your 100 shares of CSCO for $1,669 and take a $231 loss.  You’ll also pay $48 for the call option.

This strategy limits your losses to $279 ($231 on the stock and $48 for the call option) or 14%.   But given the dire forecast CSCO just issued, the losses from continuing to hold the stock could easily exceed $279.

Remember, your losses are limited to the cost of the call option, in this case $48.  But your loss from continuing to hold CSCO will be even bigger if it falls below $16.21.  In fact, CSCO could easily fall below $14 per share if Europe continues to fall apart.

But replacing the stock with a call option does more than just limit your downside.

The call option gives the ability to recoup your losses and even profit if CSCO’s stock rebounds later this year.

In order for the rescue to be successful, we need to recoup $279.  That means you’ll breakeven on the trade if CSCO rebounds back to $21.79 by the time October options expiration comes around.

And there’s a good chance CSCO will rebound into the mid-$20 range if their dire assessment of Europe doesn’t play out as they expect.

In essence, replacing the stock with a call option limits your risk to the European crisis.  And if Europe gets things figured out in the next few months, you’ll be able to recoup your losses and even profit as CSCO makes a sharp rebound.

Good Investing,

Corey Williams

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Category: Stock Options To The Rescue!

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.