With the economic recovery crawling forward and uncertainty rising because of a host of macroeconomic factors (the end of QE2, China's real estate market, commodity price inflation), investors should expect the market to trade sideways for some time at best. Nevertheless, there is one way to boost your portfolio's returns during this period: options.
Before you roll your eyes and move to the next article, give me a chance to walk you through one straightforward strategy and present you with five trade ideas. It could change the way you think about investing in the current environment.
Bullish on a stock? That's what calls are for.
First, we need to get some basics down. A call option gives you the right to purchase a stock at a set price (the "strike" price) within a certain time frame. Buying a call with a strike price above the current stock price typically means you are bullish on the stock; indeed, it makes sense to be willing to pay a premium to the current price for a stock in the future only if you expect the price to rise beyond the strike price.
For example, if you think that Citigroup (NYSE: C) shares are headed higher over the next seven months, you can buy the January 2011 $38 call for $3.63 (Citigroup shares closed at $37.92 on Friday). If the stock is trading at $48 when the call option expires, the call will be worth $10 ($48 minus $38; remember, it gives you the right to buy a share that is trading at $48 for $38). Your net gain is $6.37 ($10 minus $3.63), for a 175% return on your initial investment, smashing the stock's 26% return over the same period.
Reducing your downside
However, if the shares are below $38 at expiration, the calls expire worthless, whereas the shares have probably held much of their value. One way to reduce your potential loss on this option trade is to offset the call purchase with the sale of a call with a higher strike price. The combination of the purchase and sale is known as a call spread. Your initial outlay -- which is your maximum possible loss -- is lower, but your upside is now capped, with the most you can earn equal to the difference between the two strike prices minus the net cost of the call spread.
Actual numbers, real profits
The numbers in the Citigroup example are purely hypothetical, but these aren't: Resident Fool options expert Jeff Fischer recommended a $30/$35 call spread on Yum! Brands back when the stock was trading near $34. Less than eight months later, Jeff closed the recommendation for a smart 78% gain, nearly twice the return on the shares over the same period.
5 undervalued stocks, 5 trade ideas
The following table contains five ideas for bull call spreads on stocks that look undervalued. On what basis am I suggesting these stocks are undervalued? 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 10-year historical range.
|
Underlying Stock/ |
Max Return |
Max Gain to Max Loss Ratio |
|---|---|---|
|
Archer Daniels Midland (NYSE: ADM), $29.54 Buy Jan/ '13 $30 Call Sell Jan. '13 $35 Call |
170% |
1.7 : 1 |
|
Cisco Systems (Nasdaq: CSCO), $15.12 Buy Jan. '13 $15 Call Sell Jan. '13 $17.50 Call |
160% |
1.6 : 1 |
|
Computer Sciences (NYSE: CSC), $37.69 Buy Jan. '13 $35 Call Sell Jan. '13 $42.50 Call |
108% |
1.1 : 1 |
|
Hewlett-Packard (NYSE: HPQ), $35.25 Buy Jan. '13 $35 Call Sell Jan. '13 $40 Call |
151% |
1.5 : 1 |
|
Medtronic (NYSE: MDT), $38.02 Buy Jan. '13 $35 Call Sell Jan. '13 $40 Call |
186% |
1.9 : 1 |
Source: Yahoo! Finance. Return figures are based on closing option bid and ask prices on June 10.
Let me be very clear: These are ideas, not recommendations. Although I suspect that these stocks are undervalued, I have not done the sort of due diligence that would enable me to determine it conclusively. Furthermore, these trades have a relatively short time horizon -- that's right, even 18 months 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.
Earning the sort of option returns I described above requires time and expertise. However, even if you lack both, you could let Motley Fool Options advisor Jeff Fischer do the heavy lifting. Of the 30 trades Jeff has completed to the end of May, 29 of them were closed at a profit, for an incredible 97% success rate.
Take the next step to earning these gains
If you'd like to learn more about adding low-risk option strategies to your portfolio, give Jeff your email address in the box below, and you’ll receive, at no cost or obligation to you, the Options Insider playbook. You'll also get access to three videos in which Jeff discusses option strategies and an invitation to a live, interactive Q&A session in which Jeff and the entire Options team will be available to answer your questions. This should be an easy decision: What's the downside to learning about a new tool for your investor toolkit?
