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2/23/05
SOMETHING FOR THE PAIN

February 23, 2005

On Friday, a Food and Drug Administration panel voted to let Merck's COX-II painkiller Vioxx back on the market. Merck’s stock exploded higher by nearly $4 to $32.61 and Pfizer, which got even better news, jumped $1.74 -- or, less than half of Merck's move.

Why? Because, as I've noted many times since Merck pulled Vioxx back in late September, Pfizer has an extremely diverse portfolio of billion-dollar drugs. Thus, the impact to Pfizer's Celebrex would be less than the impact of Vioxx to Merck. That said, other than those unfortunate folks who have bleeding ulcers, do any of you see a surge of business back to either Vioxx or Celebrex to pre-disclosure levels? I thought not.

WHAT THE OPTIONS MARKETS ARE TELLING ME

This week, the markets must try to overcome the jump in crude oil prices, from $42 up to $49 per barrel. The reason for that run, as our subscribers in the Northeast already know, is the cold front that has sat on the Eastern seaboard like a sumo wrestler at an all-you-can-eat buffet!

As you can see from the NYMEX crude graph below, the futures have rallied fast and furious since touching $42 just weeks ago. If they cooperate and follow the same script that the stock market has -- that is, trade to the upper end of the range and then back down to the lower end of the range -- then the market should be happy. If, however, crude breaks above $50 per barrel and holds there (thus making that support), then say adios for the short term.




Clearly, I think the odds favor the former, but $50+ crude will certainly test United Airlines and ATA because both lack the credit to hedge, thus dooming them to hemorrhage money the longer crude stays high.


CATCHING THE CHANGEWAVE -- MERGER MANIA

Longtime subscribers to my options services know my mantra is twofold:
1) Don't enter a trade without a catalyst.
2) Follow the money!

I know this week's trade has both a compelling catalyst and smart money participation, but to that, let's throw in one of the most dynamic forces moving markets this year: A MERGER!

The stock is MCI (MCIP) and anyone with a pulse in M&A is all over this one, as Qwest and Verizon are competing for one of the crown jewels of Internet and telecom. In fact, hedge fund buying has pushed MCI's share price to a $1.90 premium to Verizon's $20.75 bid, but it’s still below Qwest's original offer for the company. Back on Feb. 14, MCI chose to accept a $20.75-per-share takeover offer from Verizon, more than $1 billion less than Qwest's previous bid that valued MCI at $24.60 a share. Now, with a revised bid from Qwest putting the gun to Verizon's head, I think shares will move north of $26 before the dust settles.






The way we play this one is to buy the MCIP June 22.50 Calls (MQIFX) and sell the MCIP June 25 Calls (MQIFE) for a net debit of 70 cents. On a 10-lot spread, you'd be putting $700 on the table, versus a 1,000-share stock purchase that would tie up $22,940. Think about that -- you're investing less than 2% of the money the stock investor has to plunk down and, yet, a move above $25 for June expiration means you make $1,800 or better than 257.1% in about 100 days! As always, with a bull-call spread like this, the risk is limited to the 70 cents per contract that you invest.

To make a limited-risk investment in MCI, I recommend buying the MCIP June 22.50-25 bull-call spread for a net debit of 70 cents.

TRADE DETAILS
All information is based on prices as of 12:20 p.m. Eastern on Wednesday, Feb. 23, 2005.

* NOTE: This example follows the most current prices available to us at the time of publication. You can still enter the trade at up to 75 cents for the MCIP June 22.50-25 bull-call spread through Wednesday, March 2, as long as MCI shares trade for $22.75 or higher.

Here is the information you need to know to buy our MCI bull-call spread for profits:

Underlying Stock: MCI (MCIP)

Current Stock Price: $22.94

Trade Type: Bull-call spread

Options to Trade: The specific trades to make are in the table below...

Action	Quantity	Option	Strike Price	Ticker	Investment
Buy	1	MCIP June 22.50 Call	$22.50	MQIFX	-$1.10
Sell	1	MCIP June 25 Call	$25	MQIFE	+.40
		Net Cost			-.70

*A minus sign (-) indicates an amount you pay; a plus sign (+) indicates an amount you receive.

Making The Trade:

If you give this trade to your broker at a net debit of 70 cents, then it doesn't matter which prices your broker pays for the individual parts of the bull-call spread. Thus, our net debit would be 70 cents, or $70 for each spread. (For those of you who are do-it-yourselfers and make the trade online, an order to buy the MCIP June 22.50 Calls (MQIFX) for $1.10 while simultaneously selling the MCIP June 25 Calls (MQIFE) for 40 cents puts you in the trade with a net debit of 70 cents to you.)

SUMMARY

With MCI trading for $22.94, a 1,000-share position would tie up $22,940. However, with our trade you'll be able to put just $700 at risk and have a potential gain of $1,800 if MCIP rises to $25 or higher.

Here’s why:

* Our net investment on that bull-call spread is the difference between what we paid for the MCIP June 22.50 Calls ($1.10) and our credit on the MCIP June 25 Calls (40 cents), or a net debit of $70 per contract.

* With MCIP trading at $22.94, a 1,000-share position would cost us $22,940.

* Instead, if we buy 10 of the in-the-money MCIP June 22.50 Calls (MQIFX) for $1.10 per contract ($1.10 each times 100 shares = $110 per contract), or $1,100 and ...

* Against that purchase, we sell 10 of the out-the-money MCIP June 25 Calls (MQIFE) for 40 cents per contract (40 cents each times 100 shares = $40 per contract), or $400.

* Thus, on a 10-contract spread we have only $700 invested, so that's all we can lose!

* If you follow these guidelines, this means your broker can pay no more than 70 cents and you avoid the risk of “legging the spread” -- that is, buying one side and waiting to sell the other.

* NOTE: Keep in mind that nobody knows your risk tolerance or financial situation better than you. A single bull-call spread in this example will cost you $70 plus commissions. As long as you maintain the ratio of one contract purchased against one contract sold, you can ramp up this strategy as big, or as small, as you’d like.

* Remember, you can pay up to 75 cents for this spread trade through Wednesday, March 2, as long as MCIP shares trade for $22.75 or higher.

TRADE PROFITABILITY ANALYSIS

Here’s how we figure out how much money we can make on this trade:

To illustrate how and where you will make money on this trade, I have included a payoff diagram at the start of this section. You can use this to follow along with my explanation below:




If you look at the shaded areas as they compare to the horizontal axis that tracks the price of MCI shares, you can see that the trade becomes profitable (green area) when the underlying stock crosses the $23.20 level. Likewise, while the stock is under $23.20, we are below the section (red area) where the bull-call spread registers a profit.

As with any 1-to-1 bull-call spread, our risk is limited to what we pay for the spread -- in this case, 70 cents.

Breakeven: $23.20

The breakeven is $23.20 because, as in any bull-call spread, the breakeven is determined by adding the net cost of the spread (70 cents in this case) to the strike price of the call you are buying. Again, because we paid $1.10 for the MCIP June 22.50 Calls and took in 40 cents for the sale of the MCIP June 25 Calls, our net out-of-pocket is 70 cents. You add that net to the strike price we’ve purchased ($22.50) and you get your breakeven of $23.20.

Max Profit: $180 per spread ($1.80 x 100 shares)

The max profit is determined by taking the difference between the two strikes of the bull-call spread, which in this case is $2.50 ($25 – $22.50 = $2.50) and subtracting the amount we paid for the spread (70 cents) and is therefore $1.80. Thus, if MCIP is $25 or higher on expiration, the spread will achieve that $2.50 max and, since we paid 70 cents for the spread, that would leave us with a $1.80 profit, or 257.1%. On a 10-contract spread, that would translate to a profit of $1,800!

*This analysis does NOT include the cost of commissions while executing your trades. Please see the note below about commissions.

OPTION COMMISSIONS

If you use a full-service broker, you may pay as much as $8 per contract with a 10-contract minimum. The broker uses a minimum to cover its cost of mailing the statement out to you. If you’ve agreed to electronic notification via e-mail, then you may negotiate both lower commissions and elimination of that minimum.

If you wanted to simulate a 1,000-share position in MCI, you’d buy 10 of the MCIP June 22.50 Calls and sell 10 of the MCIP June 25 Calls. This 10 x 10 bull-call spread could run you as much as $160 ($8 x 20 contracts). On the other hand, if you trade online through a discount broker, you could pay less than $50.