This is Like Buying A Ferrari for 15 Cents on the Dollar

by David Eller

If you could buy a Ferrari for 15 cents on the dollar, you would, right? How about if you could trade a high-value stock for a fraction of its selling price?

Well… you can. And it’s not terribly difficult…

But first, let me briefly explain why you should be focusing on exactly these types of high-value stocks in the weeks ahead.

Big Ben Bernanke’s announcement last week ensured that professional money managers now have to compete with one another to juice returns in the last quarter of the year to lock in their bonuses. Only 7% of money managers this year are outperforming their indexes, so they’re desperate to generate performance. Nervous headlines out of Europe and poor earnings for stocks like FedEx (NYSE: FDX) may create some volatility, but the bottom line is that the Fed has started a race for performance into year end.

What should we buy? Big market cap, highly liquid stocks with low downside risk. Unfortunately, not all of us can afford to buy shares of companies like Google (Nasdaq: GOOG) or Apple (Nasdaq: AAPL). So what's the best way to take advantage of these Wall Street darlings?

Deep-in-the-money options! Since many technology companies don't offer dividends, investors can be ambivalent to buying shares or buying options. For a fraction of the price you can capture the bulk of the move in the stock price by buying deep-in-the-money calls or puts.

Play Apple on the Cheap…

Let's take a look at an example. We now know that Apple is going to be able to meet its expectations for September earnings because the iPhone 5 is shipping before quarter end. In fact, since the iPhone was delayed in the September quarter of 2011, the year-over-year growth rates are going to look great!

If your time frame for holding Apple is through the next big event, which would be September earnings, we can take a look at calls expiring on October 20. A person could buy $600 calls for $103 that expire on October 20. This would give you the same exposure as buying the stock outright at only 15% of the cost.

The strike price of the option ($600) plus the option price ($103) equals the price of the stock ($603). For every dollar the stock price increases, the option price will increase by one dollar, as well…

Usually when you buy an option the price includes some extra padding called a “time premium,” which disappears as you get closer to the expiration date. In this case though, because you're buying deep-in-the-money calls, you can reduce the time premium by paying more. By paying $103 you've eliminated the time premium altogether and you’re essentially renting the stock until October 20.

Here’s the Catch…

Of course, you don’t get something for nothing. So, here's the catch: TIMING! You not only have to be right about the direction of the stock in the window that you purchased it. If the stock goes down, you lose a much greater percentage since the cost basis is $103 versus $700. So it's important to only do this with stock that’s likely to go up from Day 1. (For example, you might wait for a pullback by a recent high flyer like Google or Apple.)

This works for lower-priced stocks, as well. Let's take a look at another example: JP Morgan (NYSE: JPM).

Because the Fed announced that it would be buying back an additional $4 billion in mortgage bonds, the holders of those bonds have a price floor under their positions. It’s very likely that they’ll receive a higher price for the bonds they currently own. JP Morgan is one of the larger holders of mortgage debt.

By announcing that the Fed would be buying back more bonds at an inflated price, investors believe JP Morgan's balance sheet will get stronger. This clearly added value to the company and is likely to cause the stock to go up between now and year end. To create the JP Morgan position through January expiration, you would buy $20 calls at a price of $20.30. JP Morgan is likely to pay two dividends of $0.30 between now and January expiration, which you’ll miss out on… but in our minds, the added leverage is worth it.

These are two examples of how buying deep-in-the-money calls can help you reap unusual rewards when the overall market and the company is strong. Just be sure to minimize risk by proper timing, scaling into a position and keeping tight stops, because if the position moves against you, losses can build quickly.

Good Investing,

David

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