1 Smoking Hot Options Trade

Buying equities on their own can be rewarding, but a well-executed options strategy can really kick a portfolio up a notch. Buying stocks is the main dish; using options is the spice.

With this thought in mind, I'd like to share with you my own homegrown options recipe that I call "The Smoking Dragon." This strategy involves selecting lumbering large-cap monsters that may not be setting the market on fire, but which have plenty of puffs left in them. The trick is finding the best ones with the most attractively priced options which allow you to extract value faster than the companies' moats can decline.

The Smoking Dragon screen
The first step is to run the Smoking Dragon screen. It's a simple query for U.S.-based companies with market capitalizations larger than $10 billion, P/E ratios below 11, price-to-book ratios under 2.0, and net cash positions.

My recent run of this screen smoked out the following results:

Data from Capital IQ, a division of Standard & Poor's.
*Net cash doesn't apply to banks.

It's an interesting cast of characters. SanDisk, Forest Laboratories, and Corning are all interesting, but would require a fairly in-depth understanding of the businesses' core dynamics. JPMorgan Chase's financials are simply too big to fully understand or believe. While Chevron looks very interesting and may require a closer look, I'm going to initially shy away from it because it requires a strong opinion on the price of oil, which I'm currently void of.

That leaves us with the most interesting name on the list: General Motors.

General optional
After the government-guided restructuring of the company, General Motors finds itself in a pretty solid state. With more than $30 billion in cash, shrinking pension liabilities, and a profitable operation, there are definitely reasons to be optimistic about GM's future. While I don't know what things will look like 10 years from now, I'm fairly sure Armageddon isn't awaiting this company within the next 10 option periods. This makes GM a perfect candidate for my Smoking Dragon strategy.

The shares are currently trading for about $28.59 each. In addition, there are a uniquely large volume of option trades and chains that are available for the stock. Investors still have five months of expirations remaining in 2011 alone. If executed properly, an investor could smoke the dragon four to five times over the next six months for double-digit returns.

Smoking the dragon
There are two ways you can play this. First, if you currently own 100 or more shares of GM stock, you can simply write a call on each position of 100. This strategy only makes sense if your basis for these shares is at today's price or lower, and you aren't extremely bullish on the stock.

If you don't own shares, one option is to acquire shares (in 100-share increments) and then immediately sell calls on each 100-share block.

Trade: If you don't currently own shares of GM at a basis less than today's price, buy shares in lots of 100. Then write ("sell to open") July 2011 $30 calls ($0.45).
Strategy type: Smoking Dragon; a defensive income strategy.
Capital required: Each 100-share lot of GM stock you purchase will cost $2,859.
Potential risks: GM could fall below our break-even price ($28.14).

However, if you don't have shares, I'd write a put at (or around) $30.

Trade: Write ("sell to open") July 2011 $30 puts ($1.99)
Strategy type: Smoking Dragon, without the Dragon; bullish, yet defensive income strategy.
Desired limit price: $1.85 or higher.
Capital potentially required: $3,000 for every put you write.

This way you don't have to purchase shares immediately. If shares run up, you pocket the $185 per contract. If shares drop, you get to own GM for $28.15 (or less) and can immediately start writing covered calls (or smoking the dragon). Rinse and repeat until the shares are finally called away from you on any strong puff. The strategy is for those who don't necessary believe in the company over the long term, but are content to ride it for profits over the medium term (usually six to 18 months).

Foolish bottom line
I've definitely strengthened my investing chops by studying the Fool's best options chefs. Whether it's Jim Gillies' secret recipe for the "Lurking Gator" or Jeff Fischer baking up your standard "Iron Condor," Motley Fool Options members have the opportunity to learn and harvest profits from some of the best options recipes this side of the Mason-Dixon line. If you don't want to miss the next dish, enter your email in the box below. You'll be kept in the loop of Jim and Jeff's latest options goodies, including the "Options Insider" playbook.