Chipotle (CMG)...great food with a great company behind it

One of the most important things I have learned from Warren Buffett's trading style is to invest in what you know...and I know Chipotle.  I typically eat there at least once a week and it seems no matter what time I arrive there is always a line.  Thankfully, their lines move quite fast and they also accept online orders so in the event I am in a hurry I can always place an order ahead of time and have it ready for me at the time of my choosing.  

That being said, I can say that I've been an owner of Chipotle since February of this year.  I was fortunate enough to get in on the action at about $101 per share, which translates to a gain of 72.6%.  Not bad huh?

Chipotle will be announcing their 3rd quarter earnings on October 21.  I have almost no doubt in my mind that they will beat the analysts' estimates.  Why will they beat them?  Well there are a few reasons, the main one being that when these estimates were calculated, I think they factored in the current economic problems and possibly not as much foot traffic in the stores.  As stated above, from my experiences, Chipotle has no problem getting a line out the door.  

So you might be thinking "well why don't you just buy some more shares then Rob?"  Well as much as I would love to load up on shares the current price of $174.50 I have been thinking about another option...and that option is to buy a call option.  

Some background before I get into the details:

By buying a call option, I am essentially paying a premium to have control over a contract (each contract is for 100 shares...so if i buy 1 contract i control 100 shares, 2 contracts is 200 shares, etc.).  I am basically entering into an agreement with someone else where I pay them to have the OPTION to buy their shares off of them at a set price, the strike price.  This all has to happen before the expiration date of the contract.  

As you can see by the above option chain, the 180 Call option for Chipotle that expires on November 19, 2010 will cost me 7.30 per share, or $730 (remember each contract is for 100 shares).  I highlighted the main things that I look at...obviously you want to pick a strike price that is attainable before expiration (this is the price of the stock you are paying for the right to buy it at.  So if chipotle doesn't get up to 180 then you are only out your cost of the contract, in this case $730).  Check the 200 strike asking price.  The reason it is only 1.65 is because the odds of such a huge gain by then are a lot lower.  

There are essentially three things that can happen should I buy that option.

1)  Chipotle goes above and beyond the 180 mark...let's say it gets up to 195 at the contracts expiration.  That would mean that my profit is 195 - 180 - 7.30 = 7.70 per share, or $770 profit for the contract...not a bad return on investment for less than two months time.

2)  Chipotle never quite makes it to 180 and let's say it closes at 178.  Our contract is worthless because why would we buy shares at 180 when we can get them on the open market for 178.  We are out our investment of 7.30 per share, or $730 for the contract of 100 shares.

3)  Let's say it is October 22, the day after Chipotle announced their earnings and the stock is up to 183.  I don't know about you, but personally I don't have $18,300 lying around to cover the cost of 100 shares of Chipotle should I want to use my call option.  If I wanted to get rid of my position, I could simply sell my option contract on the open market.  When we first bought the call option we did a "Buy to Open" trade.  In order to close our position we can execute a "Sell to Close" trade.  The plus side of this is we will get any intrinsic value associated with our position as well as any time value.  A simple way to explain this is to consider the following:  What would you pay more for, a contract that expires in a week or one that expires in 2 years?  The obvious decision is that having 2 years will allow for a stock to have plenty of time to grow thus giving you a much higher probability to reach your strike price.  In the case for Chipotle, if the stock price was at 183 on October 22, we'd have about a month left of "time value" incorporated into our option.  So while we only have an intrinsic value of $3 per share (183 - strike price of 180), the time value will be there still as well, possibly $6 or so it really depends on current market conditions and how much open interest there is.  So long story short, we can resell our option at any time up 'til its expiration and either make a hefty profit or cut our losses.

One question people always ask me is "Well what's in it for the other guy to sell you a call option?" 

The simple answer is they get cash flow via the premium you pay to have control over their shares should they reach the agreed upon strike price.  I am both a buyer and seller of call options, but we'll get to the selling part at a later date.  

Hope this post was more informative than confusing.  If anything needs further clarification leave me a comment and I'd be more than happy to try to explain it another way.