This is a funny market: Much of it is overvalued, but there are certainly some pockets of value. However, with the imminent end of the Federal Reserve's bond-buying spree and fears that the recovery may be stalling, now is not necessarily the best time to wade into individual stocks, albeit undervalued ones. Cheap can easily become cheaper still. Instead, there is a stock-related strategy that provides you with income up front and only commits you to buying the shares at a price that is below the current market price.
Options 101: Put options
When you buy a put option, you acquire the right to sell shares at a predetermined price (the strike price) on or before a specific date. On the other hand, if you're selling the put, you receive the price of the put (premium) up front and you are committing yourself to buy the shares at the strike price, should the shares drop to that level. As such, you should only sell puts at a strike that you believe represents an attractive price for the shares (if the puts are exercised, your actual cost basis will be lower than the strike by the amount you received in premium).
This point is critical: Before you execute this option trade, you need to know what you'd be willing to pay for the shares -- that will determine the strike price of the puts you sell. This is a relatively low-risk income strategy, if you apply it only to stocks that you are comfortable owning at a price you are comfortable paying. In the current market, two sectors offer many such opportunities.
Large-cap tech is ripe to produce option profits
According to data compiled by Bloomberg, technology shares are the cheapest they've been relative to the S&P 500 in more than a decade (on the basis of their price-to-EBITDA multiples. EBITDA, or earnings before interest, taxes, depreciation and amortization, is a measure of cash flow).
At current levels, it's certainly tempting to buy large-cap technology stocks. The trouble is that their underperformance -- which has already lasted much longer than one would reasonably expect -- could well continue. By selling puts on the stocks in the table below, you earn income up front. If the puts are exercised at expiration, you keep that income and you buy the shares at a discount to current prices.
At those levels, they are almost certain to find support from value investors who can't resist fire-sale prices (hedge fund honcho John Paulson revealed in a May 16 filing that his firm owns a billion-dollar stake in Hewlett-Packard
| Forward P/E* | 5-Year Annualized Price Return | |
|---|---|---|
| Hewlett-Packard | 7.2 | 2.2% |
|
Broadcom |
12.5 | 0.1% |
|
Intel |
9.5 | 3.6% |
|
Microsoft |
9.0 | 1.0% |
*At June 6, based on EPS estimates for the next 12 months. Source: Capital IQ, a division of Standard & Poor's.
Large-cap banks
A similar situation exists with regard to large-cap banks, whose long-term stock performance has been dismal (in fact, financials and technology are two of the three worst-performing sectors in the S&P 500 this year). Not only that, but because of the significant regulatory uncertainty and dim prospects for loan growth, there is good reason to believe that those shares will be dead money over the next one to two years.
Sure, the valuations look cheap, but instead of buying the shares, you could sell puts on them to earn income immediately, without tying up your capital. The banks in the following table look like promising candidates for this strategy.
| Forward P/E* | 5-Year Annualized Price Return | |
|---|---|---|
|
US Bancorp |
11.0 | (5.0%) |
|
Wells Fargo |
9.4 | (4.7%) |
|
PNC Financial |
10.1 | (3.0%) |
*At June 6, based on EPS estimates for the next 12 months. Source: Capital IQ, a division of Standard & Poor's.
Selling puts on well-chosen individual stocks is just one low-risk strategy Jeff Fischer recommends to Motley Fool Options members. If you still don't believe you can make consistent profits from options, you should know that of the 30 completed trades recommended by the service so far, 29 of them were closed at a profit. That's a 97% success rate!
A risk-free next step to options success
If you want to know more about what option strategies could do for your portfolio, simply add your email address below, and you'll receive -- at no cost or obligation to you -- the Options Insider playbook, plus access to three videos in which Jim Gillies and Jeff discuss option strategies and a live, interactive Q&A session in which they will be available to answer your questions. This should be an easy decision: What's your downside to learning about a new tool for your investor toolkit?
