With the large run-up in stock prices since August, investors should expect the market to trade sideways for some time (at best!). Nevertheless, there is one way to boost your portfolio's returns during this period: options. Before you roll your eyes and click on the next article, give me a chance to walk you through one straightforward strategy and present you with five trade ideas. It could change the way you think about investing in the current environment.
Bullish on a stock? That's what calls are for.
First, we need to get some basics down. A call option gives you the right to purchase a stock at a set price (the "strike" price) within a certain time frame. Buying a call with a strike price above the current stock price typically means you are bullish on the stock; indeed, it only makes sense to be willing to pay a premium to the current price for a stock in the future if you expect the price to rise beyond the strike price.
For example, if you think JPMorgan Chase (NYSE: JPM ) shares are headed higher over the next six months, you can buy the June 2011 $45 call for $3.10 (JPMorgan shares closed at $44.75 yesterday). If the stock is trading at $55 when the call option expires, the call will be worth $55-$45 = $10 (remember, it gives you the right to buy a share that is trading at $55, for $45). Your net gain is $10-$3.10 = $6.90, for a 223% return on your initial investment, smashing the stock's 22% return over the same period.
Reducing your downside
However, if the shares are below $45 at expiration, the calls expire worthless, whereas the shares have likely held much of their value. One way to reduce your potential loss on this option trade is to offset the call purchase with the sale of a call with a higher strike price. The combination of the purchase and sale is known as a call spread. Your initial outlay -- which is your maximum possible loss -- is lower, but your upside is now capped, with the most you can earn equal to the difference between the two strike prices minus the net cost of the call spread.
Actual numbers, real profits
The numbers in the JPMorgan example above are purely hypothetical, but you could have earned the following returns. Resident Fool options expert Jeff Fischer recommended a $30/$35 call spread on Yum! Brands (NYSE: YUM ) last February with the stock trading at near $34. In October, Jeff closed the recommendation for a smart 78% gain. Around $48, the shares look fully valued -- the same strategy no longer looks appropriate (although bears might consider a bearish put spread).
5 Undervalued stocks, 5 trade ideas
The following table contains five ideas of bull call spreads on stocks that look undervalued. On what basis am I suggesting these stocks are undervalued? They are the product of a screen I created using Capital IQ; all have a forward price-to-earnings multiple in the bottom quintile of stocks in their primary industry and a trailing price-to-earnings multiple that is in the bottom quintile of its historical range (going back to January 1995).
Max Gain to Max Loss Ratio
Exelon (NYSE: EXC ) , $43.27
Buy Jan '12 $42.50 Call
Sell Jan '12 $47.50 Call
Baxter International (NYSE: BAX ) , $49.84
Buy Jan '12 $50 Call
Sell Jan '12 $55 Call
Pfizer (NYSE: PFE ) , $18.35
Buy Jun '11 $18 Call
Sell Jun '11 $20 Call
Supervalu (NYSE: SVU ) , $7.32
Buy Jan '12 $7.50 Call
Sell Jan '12 $10 Call
H&R Block (NYSE: HRB ) , $13.71
Buy Jul '11 $14 Call
Sell Jul '11 $16 Call
Source: Yahoo! Finance. Return figures are based on closing option bid and ask prices on Jan. 21, 2011.
Let me be very clear: These are ideas, not recommendations. Although I suspect these stocks are undervalued, I have not done the sort of due diligence that would enable me to determine it conclusively. Furthermore, these trades have a relatively short time horizon -- that's right, even a full year is the short term when it comes to stocks -- so identifying a catalyst for a revaluation in the share price would be extremely useful here. That would certainly require detailed bottom-up research.
Take the next step to earning these gains
If you have the time and ability to do that type of research, you can earn the sort of option returns I described above. If not, you can still put options to work for you by following the recommendations of options expert Jeff Fischer. Jeff invests part of the Motley Fool Pro's $1.4 million real-money portfolio in options, and he has built an impressive record of consistently profitable option trades. If you'd like to begin turbo-charging your portfolio's return using option strategies, simply add your email address to the box below and Jeff will send you his free report, 5 Pro Strategies for 2011, along with an individual invitation to join Motley Fool Pro when it reopens this month.
This article was first published on Dec. 9, 2010. It has been updated.