Everyone likes getting a bargain, especially on high-quality products. But when it comes to the stock market, that search for bargains can be a long one. That's especially true right now - after the rally that started in mid-March has propelled so many stocks to new yearly highs.
But here's what most investors don't realize: While it may be hard to find truly undervalued stocks, there is a way to buy perfectly valued shares at a substantial discount to their market price.
At times, that discount can equal 20% or more.
What's more, this strategy can be utilized in virtually any market environment: It doesn't matter whether the bulls are running the show, as they have been recently, or if the market is suffering from a "fiscal hangover," as it was in early 2009.
The technique is known as "selling cash-secured put options" - and, while trading options is viewed as complex and scary by many investors, this particular play is both simple in execution and relatively low in terms of risk.
Here's how it works.
[mm-toolbar]Assume you've decided you want to increase the international exposure in your portfolio, but only under two conditions:
You've looked at several companies and you think Kraft Foods Inc. (NYSE: KFT), a leading producer, packager and distributor of quality food products meets both of those requirements.
After all, the Kraft brand is quite well respected worldwide. The company, in its last full fiscal year, got 42.8% of its $41.93 billion in revenue from international sales, with $8.24 billion (45.8%) of that coming from developing countries. Sales from those fast-growing markets are likely to rise sharply in the months and years to come as the global economy continues to recover and the growing ranks of middle-class consumers in those nations demand more modern grocery stores and food products.
Kraft shares also pay an annual dividend of $1.16, a yield of roughly 4.18%.
But here's the thing. With Kraft's proposed buyout of Cadbury still creating some uncertainty, you feel the stock might be a bit overvalued at a recent price of $27.72 a share. You believe that $26.00 a share represents "fair value." But how can you get the stock at that price?
Let's assume you were planning to buy 300 shares (the minimum I recommend for this strategy), and thus have at least $8,316 in available cash. Rather than using that to buy KFT stock at $27.72, you post it as security for the cash-secured sale of three KFT June put options with a "strike price" of $26.00 a share. (Each standard option represents 100 shares of the underlying stock, so three puts would equate to 300 shares.)
As the seller of three June $26.00 KFT puts, you give the put buyer the right to sell to you 300 shares of Kraft Foods stock at a price of $26.00 per share any time up until the expiration date, which in this case would be June 18, 2010. In exchange for selling this right, you receive a "premium" (payment) from the option buyer of $1.00 per share - or $300), as quoted yesterday (Monday) - which you can either take out or use to reduce the $8,316 security deposit on the "cash-secured" transaction.
Now what happens?
For you, there are three possible outcomes:
You can use this strategy with any stock on which listed options are traded. There's only one real drawback: If the stock rises sharply, you'll miss out on the gain because you didn't buy the actual shares. But, you'll still have the premium you received - and you can continue selling puts on the stock every two to four months until its price does fall back and you finally get to buy it. Plus, if you decide at some point you no longer want to own it, you just stop selling new puts.
You can adjust this strategy in a number of ways:
As for other caveats, there's only one: Employ this strategy only with stocks you know and really want to own. The options textbooks give lots of formulas and figures, but they don't mention the fundamentals, causing many option investors to get creamed when a stock they don't really understand unexpectedly moves against them.
If you're like the Kraft investor - looking for stocks with more international exposure and a decent dividend that you can buy at a discount - here are two others I recommend for this strategy:
[Editor's Note: Twenty picks. Twenty winners. For the past year, Money Morning's Keith Fitz-Gerald has maintained a perfect record with his Geiger Index advisory service. Every trade turned a profit. That's remarkable in any market, but given the current circumstances, the service offers unparalleled security and profit opportunities. To find out what other investors have to say about the service, as well as the secret ingredient that makes the Geiger Index go, read on.]
News and Related Story Links:
