Two Option Strategies for Value Investors

Options are tailor-made to help value investors boost returns, says RealMoney's Tim Melvin. Here's why with a few timely examples.
By Tim Melvin ,

This was originally published on RealMoney on May 1, 2008 at 2:59 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

One of the most amazing things I have noticed in my 20 years around the financial markets is how dogmatic the players are.

Value guys think

growth guys are crazy. Growth guys think value investors are missing the point of it all. Stock investors eschew options and other forms of

derivatives.

Option traders think traditional stock investors are more than a little stodgy. Everybody agrees that the

futures traders are insane gunslingers.

For many years I was as bad as everyone else, sticking rigidly to the principles of value and distressed-securities investing as I had learned them over the years. About eight years ago, through the generosity of a certain barefoot New York speculator, I was introduced to a new way of looking at the markets. I could add certain instruments and techniques to my basic investing style and gain incremental returns.

Chief among these tools was the use of options to enhance portfolio returns. Although most value investors eschew options altogether, I have found them extremely useful as a way to enter and exit positions while collecting premiums. Truth be told, options are tailor-made for a value style. You can sell overpriced options on underpriced stocks and add several percentage points to your returns.

Two Ways to Play

There are two basic option strategies that, in particular, have a great appeal to me. One is the selling of cash-secured puts on stocks I want to own at lower prices. Cash-securing a

put simply means that I am putting up enough cash to pay in full for any shares that I might be forced to buy.

So, for example, if I am selling 10 puts on a stock at a $10

strike price, I will put up the full $10,000 rather than just the exchange minimum margin. When you do this, selling puts, far from being the high-risk strategy that many brokerage firms' compliance and margin clerks would lead you to believe, has the exact same risk profile as selling a covered call. If the stock goes below the strike price, you have the market risk of the position. If it goes up, you keep the premium for small gain. It is exactly the same.

I use fairly strict conditions to put these trades on. The market has to be down, and

volatility needs to be high. In a perfect world, I like to see the VIX

CBOE Volatility Index about two standard deviations above its 20-day average. At such times I can be reasonably sure that the options I am selling are somewhat overpriced and that I am not buying Cubs tickets for an options trader somewhere in Chicago.

I have to like the stock and be very comfortable, if not ecstatic, at getting put the stock at the strike price minus the premium. I only sell

out-of-the-money options and never overwrite or sell

in-the-money options, hoping the stock rises above the strike in the holding period.

I also sell short-dated options. If I were putting on a trade today, I would only use May and June options. Any longer invites too much uncertainty in my mind. I really like using this strategy with some of the stock screens I have developed over the years that reveal stocks that deliver most of their outperformance in the later portion of the holding period.

I

talked about one such screen not long ago. The Value Line top-ranked stocks with the highest projected appreciation and low debt-to-capital ratios deliver most of their outperformance in the last year of the holding period. This makes them perfect candidates for selling short-dated puts in the first year, to collect premium and gain incremental return.

Right now, the market is too high and volatility is too low, but if stocks that make the list, such as

Calloway Golf

(ELY) - Get Report

or

Staples

(SPLS)

, were to decline, and if the VIX increased, I would consider selling puts.

Playing the Combo

The other trade I really like to use is the combination trade. This means simply buying the stock and selling a put below the market and a call above the market. Unlike selling puts here, I want to be selling long-dated options to collect as much premium as possible. I use this trade when three conditions are met:

    I like the stock and am comfortable with a partial position at the current price.

    I am willing to buy more at the lower strike minus the premium collected.

    I would be happy to sell at the higher strike plus the premium collected.

    I usually use this strategy with stocks that are severely undervalued and somewhat distressed. I have used it this year to put on positions in troubled stocks such as

    Borders

    ( BGP),

    Ford

    (F) - Get Report

    and

    Charming Shoppes

    (CHRS) - Get Report

    .

    A good example of the trade right now would be Borders. You can buy the stock at $6.44. Then sell the January 2009 $5 put for 85 cents and the January $10 call for 65 cents. If the stock stays between $5 and $10, I keep the $1.50 premium. That's 23% of the current stock price. If it gets called away at $10, I keep the premium and sell stock at $10, a total return of about 70% on my money. If it falls below $5, I keep the premium and buy more stock at an effective price of $3.50. No matter what happens, I am pretty happy with the outcome. Two of three possibilities are home runs over eight months, and in the third case I double down at low prices on a stock I like.

    One of the most valuable lessons I have learned in my years in the market is that dogma, while it may be the title of an excellent movie, is a poor approach to the markets. Always be open to ideas and concepts that can improve your returns or lower your risk.

    This was originally published on

    RealMoney

    . For more information about subscribing to

    RealMoney,

    please click here.

    At the time of publication, Melvin was long Borders, Charming Shoppes and Ford, although positions may change at any time.

    Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback;

    click here

    to send him an email.

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