Examine Options to Boost Your Returns

In the past few months, I've been pounding on one theme as often as possible--large-cap, high-quality companies comprise one of the few pockets of value in today's market. Large caps are, by and large, cheaper than small caps, and high-quality companies are cheaper than low-quality companies. One way to take advantage of a pretty attractive investment opportunity is to purchase shares in one of the approximately two dozen wide-moat companies that are trading at cheap enough prices to merit a 5-star rating.

You could also buy long-dated call options--known as LEAPs--on these undervalued, high-quality stocks, a strategy that could generate significantly more upside, but which would also be riskier. (Sorry--that risk/return tradeoff never goes away.) Normally, I'm not much of a fan of options because--for reasons we'll get into in a moment--the return you receive from an option position is affected by many things other than the fundamentals of the underlying security. However, the current blasé attitude of the market toward risk has, I think, caused undervaluations for some options, which spells opportunity for investors willing to take on some risk.

Option Basics
As a refresher, an option gives the holder the right to buy or sell a stock at a certain price (the "strike") at any time until the option expires. For example, if I own Acme options with a strike price of $30 that expire in October, I have the right to buy (if I own calls) or sell (if I own puts) shares of Acme for $30 at any time between now and October. If Acme shares were trading for $35, the calls would have some degree of intrinsic value--after all, the ability to buy Acme shares for $30 is valuable if the shares are being quoted at $35 in the open market. Conversely, with Acme shares at $35, the puts would have relatively little value--why would someone want the right to sell Acme for $30 when he or she can receive $35 in the market?

Basically, when you buy a call option, you're hoping that the shares will trade above the strike price at some point prior to the option's expiration. That last phrase--"prior to expiration"--is what can often get investors into trouble with options. You could be dead right in your prediction that a stock will trade above a certain price, but if the stock doesn't do what you'd predicted until after your options expire, your position expires worthless. (Equities, of course, don't expire.)

More Risk, But More Return
So why bother with options at all? Three reasons: First, the timing problem can be mitigated by buying LEAPs, which are options that have a lot of time left until expiration. Second, your percentage returns from an option position can be much greater than a comparable position in the underlying stock. Third, some options are historically cheap right now.

Let's deal with timing first. If I buy call options that don't expire until 2007 or 2008, then I have some time for the market price of the underlying shares to catch up to my estimate of intrinsic value. If the stock does not move in that time frame, I'm still left with a worthless position, but I've left myself a decent amount of time for my investment thesis to play out.

On the return front, an option position will provide a much higher return if your investment thesis plays out. (And a much lesser one--complete loss of your investment--if it doesn't.)

Here's an example.  McDonald's (MCD) trades for about $28, and Morningstar's fair value estimate for the shares is $35. Assuming that Mickey D's shares appreciate to our fair value estimate by early 2007, an investor who purchased shares at $28 would receive a 25% return. The comparable options position would earn a much higher percentage return--McDonald's LEAPs expiring in January 2007 with a strike price of $30 are currently quoted at about $2.70, and they would be worth $5.00 at expiration if McDonald's shares trade for $35. (The option value of $5.00 is equal to the market price at expiration--$35--minus the strike price of $30.) Of course, if McDonald's shares don't move at all--or decline--over the next 18 months, the shareholder still owns the shares, but the optionholder loses 100% of his or her investment.

LEAPs Are Cheap
The foregoing is nothing new--offer the potential for higher returns in exchange to taking on more risk, and using LEAPs can mitigate some of the "timing risk" inherent to using options. However, LEAPs are especially attractive right now because the market's expectations for volatility are quite low, historically speaking, and volatility is one of the main components of the most common option-valuation model. (The more volatile a stock is, the higher the likelihood that it will be above or below the relevant strike price at expiration--so higher volatility equals a more expensive option, and lower volatility equals a less expensive one.)

The CBOE volatility index--or VIX--has been heading straight south since late 2003, and currently stands at its lowest level since the mid-1990s. In other words, the market is not expecting stock prices to move around much, and so there's relatively little volatility premium being priced into many options right now. So, you're paying less today for many options than at almost any time in the past decade.

Where the Rubber Hits the Road
Of course, don't forget that LEAPs can go to zero, unlike most stocks. Buying long-dated options in the current low-volatility environment mitigates some of the risk inherent in options, but all options have a finite life. So, one strategy might be to buy a small basket of LEAPs on undervalued high-quality stocks. If some move upward but some decline or stay flat, your returns from the winners may compensate for the total loss on the contracts that expire worthless.

Another interesting approach might be to target individual LEAPs that have lower implied volatility than the valuation-based moves one might expect in the stocks price. In other words, LEAPs that are being priced as if the stock won't move much, even though you think there's a compelling fundamental reason why the stock will rise substantially. (The volatility component of an option's price is based on the historical volatility of the stock price, not the fundamentally based expected return.) I looked up a bunch of at-the-money, January 2007 LEAPs on 5-star stocks, and each of the following had implied volatility lower than, or close to, the annual return one might expect from the stock if it appreciates to our fair value estimate:  Biogen IDEC (BIIB),  Boston Scientific (BSX),  Anheuser-Busch (BUD),  Coca-Cola (KO),  UPS (UPS), and  InterActive Corp (IACI).

In a potentially low-return stock market, buying some undervalued LEAPs on undervalued stocks can be an interesting way to add some bang to your portfolio. Just bear in mind that with options, you have to be correct about the magnitude, timing, and direction of a stock's price movement--with stocks, you just need to get the direction right, and that can be hard enough. In a prolonged down market, stockholders would thrive by reinvesting dividends, while optionholders would be left with nothing at all. That's something to think about before leaping into options. (Sorry, I couldn't resist the pun!)