The article below is going to be a question on my final intro to finance markets

Question

The article below is going to be a question on my final intro to finance markets exam this morning. Could you please explain this in simple terms to where I can understand whats going on. Please specify anything that you think has importance. Thank you in advance...I will rate/comment :)

FORBES ASAP ARTICLE ON DELL

SHOW ME THE MONEY

Dell makes more money gambling on its own stock than it does selling computers.

How much more? In the past three years, Dell has made more than $3.1 billion playing the market, while the company's net income was just $2.5 billion.

The key to Dell's success is this lucrative sweepstakes is betting that its stock will go up by selling "puts" and buying "calls." A put is an option to sell stock at a certain price. In a typical arrangement, an investment bank buys the right to sell Dell its own stock at a price below the current market value. In essence, the investment bank is betting Dell's stock will go down; Dell is betting it will go up....and it has: Since February 1996, Dell's stock has grown more than 4000%. That means mountains of cash from all those expired puts.

No wonder other tech companies like Intel and Microsoft are playing the game. In fact, in the third quarter if 1998, Microsoft pocketed an estimated $225 million from the sale of puts alone. The Redmond, Washington, software company's revenues in the same time period were $3.95 billion.

If selling puts weren't lucrative enough, Dell goes one step further. It takes its pile of put cash and uses it to buy a plethora of calls - an option to buy a stock at a certain price above the current market price. Again, Dell is betting that its own stock will go up and up.

But what happens to Dell if its stock doesn't continue to go up and up? The liabilities could be huge - say $3.1 billion in the other direction. Is any of this illegal? Apparently not. Only professional athletes can't bet on their own team to win. But the game of playing puts and calls, and the inflated bottom lines that result, is just another example of the death of good old reliable earnings reports.

Forbes ASAP April 5, 1999

Explanation / Answer

Let me define the Call and Put option First:

Call Option for is a right to buy a stock at a certain price. So buyer of call option hopes that Stock price will go up and he will get benifit.

Put option is right to sell a stock at certain price. Buyer of a put option hopes that price will go down and he will get benefit. On the other hand, writer or seller of Put option

In the current case of Dell, they are selling put option and buying call options. It means they are pretty confident that there stock will not go down and in both the transactions, they will get benefit. This confidence must be coming from there knoweledge of business better than anyone in the street in the past and they must have felt that the stock is undervalued significantly. Also, Dell must be sitting on good sum of cash. Even if stock falls and they have to buy stock at lower levels, it will be like buy back of the stocks. However, for an analyst who is covering the Dell stock, more important is the core business earnings and not the earnings from Calls and Puts, as this Income cant be predicted.

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