A beautiful thing about options investing -- and as co-advisor of Motley Fool Options, I'll admit to some up-front bias here -- is the sheer breadth of opportunity to make money. Expect a stock to rocket? There's a strategy for that! Expect a stock to plunge? There's a strategy for that! Expect a stock to be flat and boring for the foreseeable future? There's a strategy for that!
My co-advisor Jeff Fischer and I search for businesses whose industry, prospects, and financials we understand. Then we formulate an up, down, or stagnate thesis, and overlay an option strategy that we hope will yield a profit.
We hold accuracy as one of our core tenets; the higher our accuracy, the more satisfied we believe you'll be with your overall portfolio returns.
Of the 28 trade sequences that have reached their natural end since we launched the service, a full 27 have resulted in positive dollar profits – an accuracy rate exceeding 96%! (Including positions that haven't reached their conclusions yet, our accuracy is 81%.) Here are a few of our favorite options strategies that you can put to use in your portfolio.
Spreading the secret sauce
When stocks look undervalued in light of known, identified catalysts, bullish spreads can be big winners. The idea is to buy one call option while simultaneously selling a call option with a higher strike price. You earn a leveraged profit when the stock ends up above both strike prices at expiration.
Consider eBay (Nasdaq: EBAY). We realized that the market didn't appreciate its rapidly growing online payment engine PayPal, or its soon-to-be-monetized online phone offering Skype. An upward stock price move of less than 1% translated to a 91% return on investment in the spread. Today, north of $30 per share, and with its majority interest in Skype sold off, we think eBay's current price reflects all of the company's prospects.
If you were looking to candidates to implement such a strategy today, you might look into automotive-safety-systems all-star Autoliv (NYSE: ALV). The company emerged from the credit wreck in excellent shape, making structural changes to improve profitability, and generating enough cash to turn a wobbly balance sheet into a fortress.
I think the stock's a bit ahead of itself, but I also believe that Autoliv's valuation would increase with each passing quarter. A bullish spread -- buying the September 2011 $65 calls while simultaneously selling the September $70 calls -- would cost you about $3.50. If the stock stays above $70 through expiration, your profit would be $1.50, or 43% in six months.
You can also set up bullish spreads using put options – for example, you might look to Best Buy (NYSE: BBY), a company beaten down in the wake of a disappointing holiday quarter and the reshifting of previous growth initiatives such as China expansion. Even with such headwinds, the stock sells for less than 10 times earnings, and should remain a cash engine. Think Best Buy can right the ship and stay above $30 through next January? You can sell the January 2012 $30 put, and buy the January 2013 $25 put. You'll net approximately $1.75 per share -- set that aside -- and at the conclusion of the trade, the worst you'll do is owe an additional $3.25 per share if the stock falls below $25.
Diagonalizing to profitability
A favorite strategy for cash-producing, slow-moving, fairly valued big blue chip companies is the diagonal spread. In this approach, you buy a long-term, deep in-the-money call option, then repeatedly write short-term call options against the owned call for income. Over a typical two-plus-year lifespan, you whittle down the net capital invested while retaining a valuable asset in the owned call. In the best cases, over the life of the owned call, you pull out enough cash from option writing to exceed the cost of the long-term option itself.
Operating-system and office-software behemoth Microsoft (Nasdaq: MSFT) is an excellent case study. The stock has stayed between $25 and $30 for most of the last decade. And while today's price means you'd be buying this tremendous cash engine below 11 times free cash flow, there tablets and cloud computing have begun to attack the company's margins. At best, I expect a slowly rising stock price from here. Diagonalizing by buying the January 2013 $17.50 calls and writing the May 2011 $27 calls would likely be a great start to creating big income on a slow/no mover.
The backbone of option profitability
Want to really goose your accuracy? Find a company whose industry dynamic or internal practices tell you it's unlikely to rise quickly, but whose downside looks limited. Then turn it into a covered-call income engine.
For example, consider video game retailer GameStop (NYSE: GME), a stock that investors widely expect to underperform. GameStop faces the twin threats of increasing competition in its key "used game resale" market, and digital downloads of games in the future. These factors suggest little chance of a runaway stock price. Yet GameStop has excellent management, allocating its copious cash flow to reduce capital in the business by retiring debt and repurchasing stock. At seven times forward earnings, and less than eight times free cash flow, I expect the downside here is limited. Buying the stock and writing three-month $20 calls -- repeatedly -- could turn this moribund name into a long-term winner.
Another idea in this vein is GPS maker Garmin (Nasdaq: GMRN). Smartphone navigation apps may have fatally wounded stand-alone automotive navigation devices. But Garmin also owns the aviation navigation and fitness GPS markets, and it has a strong presence in marine GPS, and nearly $11 in cash/investments. Unlikely to run or plunge, repeated covered calls on Garmin could annualize out to 20%-to-25%. Best of all, you'll get a fat dividend, too.
The Foolish bottom line
We like positive returns that put cash in your pockets. Options let us do so with myriad strategies, betting on stocks that go in any direction. If you'd like to learn more about Motley Fool Options or receive our free "Options Edge" guidebook for 2011, just enter your email address in the box below.
