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Stock Strategist

Your Edge With Options

With volatility so low, some options offer attractive expected returns.

I like it when the market is scared. Usually, widespread fear--about the Fed, earnings, Osama bin Laden, the economy, anything--leads to lower stock prices, which means more bargains for long-term investors.

Generally speaking, you don't find as many attractive investments when the consensus is rosy, because the expected returns on most assets have already been bid up to unrealistic levels. At the moment, for example, you're seeing small spreads on low-quality bonds, indicating that fixed-income investors are willing to be paid less to take risk, as well as a very low Chicago Board Options Exchange volatility index, which means that professional options traders are not expecting much equity-market volatility in the near future. In fact, many of these fear indicators are back to the absurdly low levels they touched earlier this year, before the late-spring sell-off in commodities and emerging markets.

However, there is one type of investment that gets cheaper the cheerier the consensus becomes--options. Options prices are determined by a number of variables including interest rates, but the key determinant of the price of the option is implied volatility. So, all else equal, options are cheaper when expected volatility is lower. Oversimplifying, you can think of volatility as a hurdle rate for options--if the hurdle rate (volatility or expected return) is low, then the underlying shares don't need to move as much for the option to be profitable.

In even simpler terms, the options market is currently offering investors a number of bets with what appear to be reasonable odds. Let's walk through some brief option mechanics, and then I'll list some specific option contracts that look attractive to me.

Nuts and Bolts
I walked through the basics of options in a previous article, so I'll just hit the highlights here as they apply to one type of option. A call option gives the owner the right to buy shares of a stock at a specific price (the "strike") at any time until the option expires. As you might quickly surmise, this right is only valuable if the shares are trading higher than the strike price, so you buy call options if you think a stock will rise in the future. The trick is that a call option is a wasting asset with a finite life span--if your bullish thesis does not play out before the option expires, you're left holding nothing but a tax loss.

The flip side is that options are leveraged investments that can deliver a greater percentage return than an investment in the underlying shares. For example,  Anheuser-Busch (BUD) LEAPs (long-term equity anticipation securities, or long-term equity options) that expire in January 2008 and have a strike price of $40 are currently trading for $9.40. If the stock appreciates from its current price of $47.50 to our fair value estimate of $57 at expiration, the calls will be worth the stock price of $57 less the strike price of $40, or $17. That's an 80% return on the original $9.40 investment, whereas owners of the underlying shares would make only a 20% return on their original $47.50 investment.

Of course, if Anheuser-Busch drops 10% to $43 at expiration, the option will be worth only $3, for a 60% loss, while the shareholder will only lose 10%. And if it drops 20% to $38, the option holder loses his or her entire investment, whereas the patient shareholder can simply wait, or average down on the position. That's leverage for you--it cuts both ways.

Your Edge With Options
So, why are some options cheap enough now to partially compensate for the increased risk? Part of the answer is that the options and equities markets are complacent and expecting low volatility, and volatility is a significant component of the most commonly used model for pricing options. (The more volatile a stock, the greater the chance that it will be above or below the relevant strike price at expiration.) In general, the lower the implied volatility on an option, the "cheaper" it is.

But investors with a fundamental viewpoint on a stock can have an edge over those who rely strictly on historical volatility of the stock price, because option prices likely don't take into account how undervalued a stock is or how strong its business may be. If you have a well-grounded opinion that a stock is trading significantly below its intrinsic value, the option may very well be mispriced relative to your expected return.

This fundamental opinion is your "variant perception," in the words of legendary money manager Michael Steinhardt, or your edge, in betting parlance. Here's an example of how you can use simple common sense to decide whether an option offers you good odds or not.

Using Your Head
Let's use those Anheuser-Busch January 2008 calls with the $40 strike. The current option contract price of $9.40 has two components: intrinsic value and time value. Since the shares trade for $47.50, the options have $7.50 ($47.50 minus $40) of intrinsic value. In other words, the right to buy Anheuser-Busch at $40 is worth $7.50--that's pretty simple. The additional $1.90 of the contract price is called time value, and represents the possibility that Anheuser-Busch will go even higher than the current $47.50 price before January 2008. As you might imagine, the longer an option has until expiration, and the more volatile the underlying stock, the higher the time value will be, because the chances are greater that the stock will be above the strike price when expiration arrives, as well as a greater chance that the stock will move far above the stock price.

If you buy 40 strike calls for $9.40 that only have an intrinsic value of $7.50, you have $1.90 of premium to "make up" before your option breaks even. Anheuser-Busch shareholders will also receive $1.48 in dividends that option holders will not, so our breakeven price is the current price of $47.50 plus $1.90 in time value plus $1.48 in dividends, which equals $50.88. So, if Bud moves up 7.1% to $50.88 and stays there until your option expires, you'll have neither made nor lost money on the option. But every point above the breakeven price offers you a much greater percentage return on the option than on the underlying stock, since the intrinsic value of the option contract will appreciate in tandem with the stock, but the gains are coming off a much smaller base investment--that's the leverage effect of the option.

By buying the option contract at $9.40 with Anheuser-Busch at $47.50, you're essentially making the following bet: If Anheuser-Busch falls, stays flat, or fails to reach $50.88 (a 7.1% move) before January 2008, your option contract loses money, and you'd be better off buying the underlying shares. So, that 7.1% number is your hurdle rate--as long as you think Anheuser-Busch will rise more than that amount in the next 15 months, the option is likely to be a good deal, since the payoff above $50.88 is much higher on the option than on the stock.

Note that the above mechanics don't hold true for all options. The example applies mainly to call options with a lot of time left until expiration, which have a large amount of intrinsic value (they're "in the money" in options jargon), and with low implied volatility. The last point is key, because the higher the implied volatility, the more time value that you'll need to make up to break even on your investment, and the higher your hurdle rate will be.

Some Ideas
I screened our 1,800-company coverage universe for stocks trading at least 15% below our fair value estimate with average or below-average risk ratings. Then I looked for companies with LEAPs expiring in January 2008 that have very low implied volatilities. (All of the contracts listed below have implied vols of 10 or less.) I came up with almost 10 contracts that require a relatively small move in the underlying shares for an option position to break even. Just remember that although an option positions offers greater upside than an investment in the underlying shares, you're also taking on a lot more risk--if the shares don't do what you think they will before expiration, the options are worth a lot less (or worthless), whereas the stock position would likely suffer a much smaller loss.

 

 January 2008 Calls
Company Option Strike Price Stock Price Break-Even Price Gain to Break Even

Morningstar Fair Value Estimate

JP Morgan (JPM) $40 $47.50 $51.20 7.8% $61
Tyco  $22.50 $29.40 $31.30 6.5% $36
Anheuser-Busch (BUD) $40 $47.40 $50.88 7.3% $57
Home Depot (HD) $25 $37.30 $39.25 5.2% $44
Medtronic (MDT) $35 $48.70 $51.25 5.2% $64
Microsoft (MSFT) $22.50 $28.70 $30.50 6.3% $34
Pepsi (PEP) $55 $63.40 $67.50 6.5% $74
AIG (AIG) $55 $67.20 $71.33 6.1% $80
Bank of America (BAC) $47.50 $53.90 $58.30 8.2% $64
Data as of 10-31-06

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