Right now, two factors are combining to produce opportunities for enormous gains on specific stocks. Below, you'll find a basket of five stock option trades I put together to benefit from those circumstances, which has the potential for a 600% 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 market's expectation for volatility, as measured by the VIX index (Wall Street's so-called "fear gauge"), has fallen to levels not seen since prior the first flare-up in the European sovereign debt crisis back in May.  

When volatility is cheap, so are options. In that context, put options on the SPDR S&P 500 ETF (NYSE: SPY) 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 (NYSE: IWM) -- small-cap stocks look at least as expensive as the broad market.

Cheap volatility, cheap stocks: Buy calls!
While the broad market is overvalued, that's not entirely the case for all stocks in the market. The table below describes a basket of call options on five 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 would 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:

Stock/ Option Trade

Current Stock Price

Jan. 2012 Stock Price Target

Option Trade % Return

Exelon (NYSE: EXC)

  • Buy 1 Jan '12 $40 Calls

$40.93

$59

511%

H&R Block (NYSE: HRB)

  • Buy 1 Jan '12 $15 Calls

$13.30

$17.50

56%

Hewlett-Packard (NYSE: HPQ)

  • Buy 1 Jan '12 $45 Calls

$41.65

$79

915%

Wal-Mart (NYSE: WMT)

  • Buy 1 Jan '12 $55 Calls

$54.21

$73

407%

Zimmer Holdings (NYSE: ZMH)

  • Buy 1 Jan '12 $55 Calls

$52.36

$91

800%

 Option Basket Trade

 

 

601%

Source: Yahoo! Finance and Capital IQ, a division of Standard & Poor's. Option return estimates are based on closing prices on Dec. 14.

Profits... and risks
A 600% return looks undeniably 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 so 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 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 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. Since the inception of the Motley Fool Options service, Jeff's 43% total return has smashed the S&P 500. If you'd like to begin turbocharging your portfolio's return by investing a small portion of your assets, simply add your email address to box below, and Jeff will send you a free report in which he breaks down several of his favorite strategies.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. Exelon and Wal-Mart Stores are Motley Fool Inside Value recommendations. Wal-Mart Stores is a Motley Fool Global Gains pick. Motley Fool Options has recommended writing covered calls on Exelon. The Fool owns shares of Wal-Mart Stores. 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.