7 Cheap Stocks, 1 Rich Trade

Right now, two factors are combining to produce opportunities for enormous gains on specific stocks. Below, you'll find a basket of seven stock option trades I put together to benefit from those circumstances, which has the potential for a 519% return. However, before we even begin thinking about earning fat returns, let's talk defense first, with a hedge idea to protect our existing assets.

Cheap volatility, expensive market: Buy puts!
As I pointed out recently, complacency is riding high right now, and investors are seriously underestimating -- and therefore, underpricing -- the potential for (downward) stock price volatility. Indeed, the VIX index (Wall Street's so-called "fear gauge"), which measures the market's expectation for short-term volatility, fell to a three-year low on an intraday basis recently.  

When volatility is cheap, so are options (in fact, the VIX is derived from option prices on S&P 500 futures). In that context, put options on the SPDR S&P 500 ETF expiring in January 2012 look like a very cheap form of insurance for your portfolio. These options rise in value as the S&P500 index declines. I expect the market to continue to trade in a range for an extended period of time (several years, not several months), and the S&P 500 looks like it is already at the high end of that range right now.

Investors could set up a similar hedge with put options on the iShares Russell 2000 ETF -- small-cap stocks look even more expensive than the broad market (although you'd have to pay up for the options in volatility terms).

Cheap volatility, cheap stocks: Buy calls!
While the broad market is overvalued, that's not the case for all stocks in the market. The table below describes a basket of call options on seven (mostly) high-quality stocks that look undervalued. The stocks 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).

The table's third column contains my stock price targets for January 2012; I assumed that the stocks' price-to-earnings multiples would get one third of the way back to their 10-year average and that the companies achieve their consensus earnings estimate for 2011. If the stocks do reach these price targets at option expiration, these are the returns investors would earn on the following option trades:

Source: Yahoo! Finance. Option return estimates are based on closing prices on Jan. 14.

Profits... and risks
No doubt about it, a 519% return looks very enticing, but let me be clear: This basket of options is a trade idea, not a recommendation. Although I suspect these stocks are undervalued, I haven't done the sort of due diligence that would enable me to determine it conclusively. Furthermore, this trade has a 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 require detailed bottom-up research.

Take the next step toward earning rich gains
If you have the time and ability to do that type of research, you can compete for 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.