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.
Assume you've decided you want to increase the international exposure in your portfolio, but only under two conditions:
- You don't want some obscure foreign stock.
- And you'd also like some added dividend income.
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:
- If Kraft's stock price rises before mid-June, the puts you sold expire worthless and you get to keep both your $8,316 and the $300 premium you received. You don't get the shares, but you've made a 3.61% return on your money in just under five months – without owning the stock. Plus, you can repeat the put sale in June, using options that expire in September or December of 2010.
- If Kraft's stock price stays flat or falls slightly, but remains above $26.00 a share – the puts you sold also expire worthless and you again get to keep both your $8,316 and the $300 premium. You still don't get the shares, but you've made a five-month return of 3.61% – and, once again, you can repeat the strategy.
- If Kraft's stock falls below $26.00 a share – say to $25.00 – the person who bought the options can "put" 300 shares of KFT to you at $26.00 per share, or $7,800 total. The money to pay for the stock comes from the $8,316 you put up to secure the original sale. Since the price is now $25.00 a share, you have an immediate loss of $1.00 per share, or $300 – but, remember, you still have the $300 premium you received, plus $516 of your original stake. So, you're actually $516 ahead (a 6.20% return on your money, or roughly 14.9% annualized) – and you got the stock at a discount of 6.2% off the price you would have paid had you bought this week.
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:
- If you want faster results and lower time risk, you can sell shorter-term options. In the Kraft example, you could sell March $26.00 puts at 45 cents, shortening the time frame by three months – but also cutting your return a bit. I advise selling puts that have at least 45 days remaining until expiration and a minimum premium of 50 cents. I also suggest trying to enter this transaction on days when the market is sharply lower because the bears get excited and push up the premiums of the puts you'll be selling.
- If the stock does pull back in that shorter time frame and you wind up buying it at the striking price, your effective discount (including the put premium) will usually equate to 15%-20% from the present selling price – plus, you'll also start collecting that ripe dividend as a bonus. (You can also begin selling "covered call" options against your new stock position … but that's another story).
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:
- ABB Ltd. (NYSE ADR: ABB) – $18.47 – This Zurich-based company provides power-generation and automation equipment to customers worldwide, and should grow nicely with the global economic recovery and continued modernization in developing countries, especially Asia. Market cap: $42.2billion; dividend: $0.43; yield: 2.30%.
- Paychex Inc. (Nasdaq: PAYX) – $29.50 – This Rochester, N.Y.-based firm provides outsourced payroll and human-resources servicesto small and medium-sized businesses in the United States and Germany. It should prosper as American and European economies recover and new businesses are formed, needingaccounting and benefits programsthey can't yet afford toprovide in-house. Market cap: $10.66 billion; dividend: $1.24; yield: 4.20%.
[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:
- Chicago Board Options Exchange:
Equity Option Strategies – Cash-Secured Puts
Covered Call Options
"Fiscal Hangover," by Keith Fitz-Gerald
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.