Option Investor

Portfolio Activity - EL

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Rally Mode!

There was some unexpected activity in the MCM Portfolio this morning as Estee Lauder (NYSE:EL) gapped higher in early trading after Smith Barney raised its investment rating on the company. The research note said the brokerage was upping its recommendation to "buy" from "hold," citing a belief that EL will have "considerable earnings power" over the next several years. The brokerage also raised its share price target to $52 from $48, and now we know the "catalyst" for the recent buying pressure in the issue.

The question is, can the rally be sustained in the coming weeks or is this announcement simply a "last ditch" effort by the brokerage to boost the share value in the near-term? More importantly, if the bullish activity continues, what is the potential risk to our position from additional upside movement? Readers who followed the LM Ericsson (NASDAQ:ERICY) play may remember a similar scenario: a bearish spread on a range-bound issue with brief rallies in a lateral price pattern. However, there are a few small differences with EL, such as its long-term (2 yr) bullish trend and the issue's recently oversold conditions. At the same time, we do not believe there is enough technical strength to propel the issue beyond the current (8 month) upper boundary, which is near $47. With that outlook in mind, we have a few alternatives to consider:

1) We can simply hold the spread and accept the outcome, closing the short position (if necessary) on the last day of the expiration period. This would involve some additional risk and require an alternate strategy to limit losses if the stock moved above intermediate-term resistance near $46.75.

2) We could transition to a neutral (calendar) spread with the purchase of the JUL-$45 call options. There would be a debit in the transaction, as we are buying time value, but the long position should retain most of its "premium" in the near-term, if the stock does not move significantly in one direction or the other. In addition, we would have a limited-risk opportunity to achieve a profit in the current (losing) spread. We outlined this strategy in the MCM Blog posted on 3/14/05.

3) A "roll-out" to a more distant, higher strike spread is not feasible as there is no $55 strike call option in July (for the long position), and we do not believe a "naked" position is appropriate for the majority of traders.

Obviously, some readers have already closed the position and that may be the best approach, based on their individual experience level, risk/reward attitude, portfolio capital, etc. However, we are also confident that a number of subscribers want to know more about effective position management techniques and some recent E-mails have strengthened this opinion. With regard to the underlying issue's current technical indications, the first alternative remains viable. But, those who want to pursue a different avenue should consider at least one possible adjustment in the EL spread. This approach, for readers who understand the basic components of the strategy and agree with a neutral outlook for the stock, involves the purchase of JUL-$45 call options to "cover" the current short position (APR-$45). This transaction would initiate a calendar spread, a conservative technique that offers less-experienced traders an opportunity to learn more about the unique advantages of selling time. We will post additional information on the strategy in the coming sessions.

MCM Staff

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