The Best Bargain You'll Find Right Now

After one of the most impressive years in stock market history, many investors are frustrated at the lack of good values among investments right now. Yet if you're willing to expand your horizons, you may find unprecedented value in an unexpected corner of the investing world.

Running the option
A year ago, most investors were extremely fearful of what the future might bring, and you could see that fear in the cheap valuations on many stocks. Those who took advantage of those bargain prices have mostly been rewarded handsomely. Gains of 100% or more have been much more commonplace than you'd ever expect, even from the low point of the financial crisis.

Now, most of that fear is gone, and investors have become complacent about the prospects for a slow but steady economic recovery and more stable stock prices. That's made stocks expensive -- but it has also brought the price of options down substantially, to the point where you should strongly consider using options in ways you might not have considered before.

Why options are smart now
Option prices depend on volatility. During crisis situations, the cost of options soars, as investors want to protect themselves from violent swings in the market. But when the crisis abates, fewer investors are willing to pay for what may prove to be unnecessary protection, and so prices fall.

By one measure, prices of options are extremely low right now. The VIX, which measures volatility levels in the S&P 500 index, has fallen to less than 18. To put that figure in context, except for a brief stint below that level in January, the last time we saw the VIX that low was in mid-2008 -- long before the worst of the financial crisis hit.

As a result, using options may make sense right now. But you have to use them correctly.

What not to do
The usual rule of "buy low, sell high" applies to options as much as any other investment. Many options strategies, including covered calls and put writing, involve selling options to reap income in the form of an option premium. But when option prices are low, selling them doesn't make as much sense, because you don't get as much in exchange for taking on the risk that your position will move against you.

In contrast, though, doing things like buying protective puts or using call options in lieu of stock positions does make sense when option prices are low. Protective puts are simple: You buy an option that guarantees that no matter how low a stock you own falls, you can sell it for at least a certain amount.

Right now, you can get that protection pretty cheaply on a number of stocks. Here are some examples:

Stock

Share Price

Put Option

Option Price

Ford (NYSE: F  )

12.80

April $12

0.29

Wells Fargo (NYSE: WFC  )

28.98

July $27

1.17

Microsoft (Nasdaq: MSFT  )

28.80

April $28

0.39

Caterpillar (NYSE: CAT  )

59.18

May $60

4.10

Source: Yahoo! Finance. Closing prices as of March 9.

If you're willing to accept a slight drop before your put kicks in, you can pay as little as 2% for more than a month's worth of protection. And even if you want to completely insulate yourself from losses, as with the Caterpillar option above, you don't have to pay a ridiculous amount.

Conversely, when call options are cheap, you can buy them in place of buying or holding onto actual shares. Doing so lets you keep any upside on the stock, but limits your losses in the event that the shares fall below the strike price of your option. Here are some examples:

Stock

Share Price

Call Option

Option Price

Apple (Nasdaq: AAPL  )

223.02

April $220

10.70

MasterCard (NYSE: MA  )

246.48

April $240

14.70

Freeport-McMoRan (NYSE: FCX  )

79.76

May $75

8.20

Source: Yahoo! Finance. Closing prices as of March 9.

For instance, say you own MasterCard stock. If you sell those shares and replace them with a call option, you'll receive a net total of $231.78 per share -- which might represent a big profit, if you bought them a while back. Meanwhile, if the price stays above $240, you'll keep the potential for further gains. But if the price plummets, the most you can lose is what you paid for the call option.

Stay smart
Options are useful because their flexibility makes them suitable in any market environment. The key, though, lies in knowing which strategies are appropriate at any given time. With options prices at extremely low levels, buying options could help you protect yourself against a sudden reversal, while still giving you a chance at more gains if the rally continues.

Want to learn more about options? Find out how Fool contributor Tim Beyers turned a simple investment in options into a double in three months.

Fool contributor Dan Caplinger likes to keep his options open. He owns shares of Freeport-McMoRan. Apple and Ford are Motley Fool Stock Advisor picks. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always gives you all the options.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2010, at 8:52 AM, bdpatty2 wrote:

    inducement to trade options has always presented a challenge to the investor who has spent many years

    investing, doing little trading and believing that option

    purchasing would put their investing into the gambling

    category

    The average, me, investor mostly depends on what

    the large corporate investor does and profits off the

    coattails of major money players, and is withou t

    expertise and insider knowledge that is sufficient to

    predict up and down activities, and therefore is

    dependent on long term investing while shorting only when public knowledge indicates a downturn in a company's values.. bulldog

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