A Foolish Options Position on Nuance Communications

Remember when I called Nuance Communications (Nasdaq: NUAN  ) a buy just last week? I followed those words up with an outperform CAPScall at the time, but I recently took it a step further by adding a position to my personal portfolio.

I already went over the reasons that I think it will be a long-term winner in the coming years, with the belief that voice-recognition technology now has the greatest potential for mainstream usage, especially when you factor in its mobile prospects, thanks in part to its role powering Apple's (Nasdaq: AAPL  ) Siri, along with TV's shift to voice technology.

It's not as expensive as you think
One of the more disconcerting aspects of the stock is its nosebleed price-to-earnings ratio of roughly 244. Much of this sky-high multiple is related to the intricacies of acquisition accounting, which is particularly relevant for Nuance since it's an acquisition machine. The company is constantly amortizing intangibles, which puts a drag on reported earnings. Looking at cash flow brings it back down to earth.

Nuance has grown free cash flow from $53.5 million in 2006 to $322.5 million in 2011. Compare those figures to the reported bottom lines of a net loss of $22.9 million in 2006 and net income of $38.2 million in 2011, and you'll see that the bottom line doesn't tell the whole story.

Sources: SEC filings for historical data, Reuters for revenue consensus estimates.

Some of its other multiples look far more reasonable. Price-to-sales sits at 6.6, price-to-cash flow is just under 42, and price-to-free cash flow is almost 28. Those are still somewhat lofty, but suddenly the stock doesn't look nearly as expensive as price-to-earnings alone would have you believe.

Fair warning
I'm using a relatively complex options strategy that isn't for the faint of heart, so keep this in mind as you read further. I'll start with a brief overview of two of the "Greeks" that I used to put together my position, namely delta and theta.

Delta is a measure of how the option price will react to changes in the underlying stock, and ranges between 0 and 1. A delta of 0.8 for a call would suggest that if the stock rises by $1, the call should increase by $0.80. You can also think of it as owning an equivalent number of shares. If you owned one call option representing 100 shares with a 0.8 delta and the stock rose by $1, you should make $80, just as if you owned 80 shares outright. Delta changes as the stock price changes, so it's not a static figure.

Theta is a measure of time decay, or how quickly the option loses time value. It measures how much value the option will lose each day, all else equal. Time decay isn't a linear affair, and accelerates near the end of an options life, so an option with three months to live decays faster than one with two years, for example.

On with the trade
I implemented a position that's analogous to a synthetic long: I sold a two-month bullish put spread while simultaneously purchasing a long-term call.

Quantity	Expiration	Strike (C/P)	Price	Theta	Delta	Net Delta (Quantity x Delta)
1	January 2014	$30 C	$6.90	(0.0045)	0.61	0.61
(2)	April 2012	$29 P	$1.72	(0.0135)	(0.40)	0.80
2	April 2012	$23 P	$0.28	(0.0063)	(0.08)	(0.16)
�	�	�	�	�	Total	1.25

Source: Author's trading platform at the time of trade.

Excluding commission, I paid $690 for the call, while bringing in $288 selling the spread, for a net cost of $402. With a total net delta of 1.25, this position should initially behave just like owning 125 underlying shares, which would normally cost over $3,700 at the price of $29.93 at the time of this trade.

By purchasing a 2014 low-theta call, I reduce my time-decay exposure hoping for long-term gains, while selling the closer puts takes advantage of their faster time decay, specifically the $29 put's larger theta. This position carries a net positive theta of 0.0099; having a positive theta is like saying time is on your side. Time is a good ally to have, since I lose every time I try to fight it. If you can't beat 'em, join 'em.

Hopefully shares stay above $29 and all puts expire worthless, I sell another spread, rinse, repeat, and eventually pay for the call entirely, free-rolling until 2014.

Low cost doesn't mean low risk
That $402 up-front cost might look attractive, but this trade still has downside risks. I bought the $23 puts, creating a spread to limit my risks and capital requirements, but if Nuance tanks below $23 and never recovers, I stand to lose a total of $1,890 ($600 on each spread and the $690 call cost), or 470% of my investment. As it stands, my breakeven point is about $34 (call strike of $30 plus roughly $4 per share net cost) if Nuance keeps climbing and the put spread expires worthless.

Since I think Nuance will be well above $34 by the time January 2014 rolls around, I like my odds.

Voice technology is just one way to play the mobile revolution, which is set to become�"The Next Trillion-Dollar Revolution." There are lots of companies that are set to cash in on it, but one in particular has excellent prospects. The company is one of a few players that will help power the mobile devices of the future, and it also has exposure to the explosive growth in China. I've given it an outperform�CAPScall.�Get access to this 100% free report�to find out what company I'm talking about.