A Better Way to Play a "Once in a Lifetime Opportunity"

Bill Miller, legendary investor and Chief Investment Officer at Legg Mason Capital, thinks that the stocks of good, quality companies are as attractive as they have been in the last 30 years. In fact, he went so far as to say they are a "once in a lifetime opportunity." In the same breath, though, Miller notes that the stocks of these companies could remain flat for quite some time

Instead of buying shares outright, Foolish investors familiar with options should consider using a diagonal call strategy for buying the blue chip stalwarts Miller finds so attractive right now. Fear not, Fools, while "diagonals" sound complicated, they aren't. The strategy simply allows us to take a long-term, mildly bullish position in great companies (just like owning shares), while defining our maximum loss and investing less cash than buying shares outright.

LEAPing into a diagonal
If you're familiar with covered calls, diagonal calls should be a breeze because they are very similar. With a diagonal, we simply buy a LEAP call option instead of buying the stock. Be sure to brush up on the basics of using options Foolishly before thinking about dabbling in this strategy.

Setting up a diagonal call involves taking two options positions:

Option Position

Details

1. Purchasing a long-term call option
  • Says: "we're willing to buy this stock, at a particular strike price, at some point in time between now and a long time from now."
  • We'll choose a strike price that represents the price we'd want to buy shares – usually well below the current share price.
  • Ideally, we'll choose an option expiring in a few years, known as a LEAP call option.
2. Selling a shorter-term call option
  • Says "we don't expect the stock to rise too far, too fast, and we'd be happy to earn some option premium income to offset the cost of our purchased call (No. 1).
  • We'll choose a strike price that is slightly above the current stock price but that still pays a satisfactory option premium.
  • Over the long life of the LEAP calls we purchased, we'll write numerous rounds of call options (No. 2), effectively earning back some or all of the cash we used up front.

By purchasing a LEAP call we can control 100 shares of the underlying stock for a much smaller initial investment than it would cost to buy shares directly. But it still costs us some cash, and with any luck we may be able to earn enough income from writing calls that we end up earning back the cash we originally forked over.

For example, if it costs us $8 to buy a two-year LEAP call, we can chip away at that cost by writing eight three-month call options for $1 each. At the end of the two years our purchased LEAP call will have been paid for by our eight $1 written calls.

When diagonal calls work best
The best candidates for diagonal calls are blue chip companies that are reasonably valued but still have promising futures – exactly the types of companies Bill Miller is urging investors to buy right now.

Company

Price-to-Earnings Ratio

Enterprise-Value-to-Free-Cash-Flow Ratio

5-Year Projected Earnings Growth

Church & Dwight (NYSE: CHD  )

17.5

21.6

12%

Amgen (Nasdaq: AMGN  )

11.6

12.9

10%

Cisco Systems (Nasdaq: CSCO  )

13.9

14.4

12%

Hewlett-Packard (NYSE: HPQ  )

11.5

19.3

11%

IBM (NYSE: IBM  )

13.1

15.4

12%

Nike (NYSE: NKE  )

22.2

19.9

12%

Tyco International (NYSE: TYC  )

17.9

18.7

12%

Source: Capital IQ, a division of Standard & Poor's.

Cisco, king of network equipment for big business and government, disappointed investors in November by predicting quarterly revenue growth of just 3% to 5%. The real issue investors had centered on the fact that Cisco's problems weren't shared by its competitors. Shares dropped 16% and have been bouncing around their 52-week low ever since.

But Cisco's products remain best of breed, the company is making some headway into the consumer space via video tools, and its bread-and-butter networking markets should continue to grow as data demands continue to bog down legacy networks. In two years, I wouldn't be surprised to see Cisco's business and share price improve considerably. With many investors down on the company and likely ignoring its shares for a while, Cisco may make an excellent diagonal call candidate.

The nitty-gritty
Cisco recently traded below $20 per share. We can buy a January 2013 call option, with a strike price of $12.50, for $8.30. This provides us the opportunity to buy shares of Cisco for $12.50, 35% below where they trade today, for a cash outlay of $830. And we've got over two years to earn back as much of that cost as we can by writing covered calls.

March 2011 calls, with a strike price of $21 (8.5% above today's share price), will pay us $0.60, or $60 per contract. Selling these call options gets us off to a good start in our diagonal strategy, reducing our initial cash outlay by 7%. But the March calls are only the first of several rounds we hope to write. The diagonal call is not a set-it-and-forget-it, Ron Popeil-style strategy. Once March rolls around, we'll need to decide whether we should buy back the written calls or let them expire before we write our second round.

The Foolish bottom line
If done correctly, a diagonal amounts to buying a LEAP call, the cost of which is returned in small chunks over time – like Pac-Man gobbling up income dots. But there are no free lunches: The stock could plummet, making our purchased LEAP call decline in value -- or the stock could rise more than we expected, requiring us to lose money on the written call portion of the strategy.

Investing in solid businesses selling for reasonable prices that will act as a foundation for your investment portfolio remains the key to successful investing. But for options-savvy investors, diagonal calls offer the opportunity to acquire excellent companies at prices well below what others must pay. If Miller's correct that shares are undervalued today but we can't know exactly when they'll run up, it could make sense to consider a diagonal strategy.

To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive information on Motley Fool Options, plus our free options guidebook.

Bryan Hinmon doesn't own shares of any companies mentioned. Nike is a Motley Fool Stock Advisor pick. The Fool has written calls (bull call spread) on Cisco Systems. The Fool owns shares of International Business Machines. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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