Friday, June 18, 2010

How To Buy Solid Stocks at 10 to 20% Discount

Readers know that I make extensive use of options, in particular straddles. Straddles can pay handsomely (as in 200%/300%+ ROIs) in volatile markets, as I have published results several times in the past few months. Phil Davis, the options guru who maintains a great trading daily chat also uses options almost exclusively, but he usually writes (sells) options. Writing options has in general an over 90% success rate, sometimes even higher so it can be quite lucrative for those with larger accounts. As myself, Phil has also appeared on BNN in Canada explaining his strategies. He has written an article on how to buy stocks at a 10 to 20% discount (sometimes more), by using options. Here it is.

How to Buy Quality Value Stocks for a 10%-20% Discount with Phillip Davis’ Option Strategies

By Phil Davis, Phil’s Stock World

If you want to concentrate on investments that give you better prices than those paid by the average retail investor, pick value stocks. This will allow you to stay ahead of the game using very basic option strategies.

The best method to work your way into new bullish positions with value stocks is with the famous Phil’s Buy/Write Strategy. This strategy is the most sensible way to initiate new stock positions using one of the most effective, time-tested tools for dealing with market uncertainty. This strategy allows you to purchase stocks for 10%-20% below their current price. The strategy is called a “Buy/Write” because we buy the stock and write/sell options against it.

Assuming that you want to own 200 shares of a stock, Phil’s Buy/Write Strategy can reliably give you a 10-20% discount off the current market price. It’s simple, easy to follow, and ideal for trading in a volatile market.

Sound investing principles include purchasing stocks that have strong underlying fundamentals, stocks we don’t mind owning for the long-term. Of course, when you buy any stock, another sound investing principle is to scale in . . . enter your position in stages. Why? Because we can’t assume our timing is perfect. By entering a position in stages, we spread the risk over time.
Selling options simultaneously with a stock purchase, using Phil’s Buy/Write Strategy is a way to automatically follow a scaling system without having to monitor the position that closely.

Phil’s Buy/Write Strategy in Action

How does the Buy/Write Strategy work? It’s very simple, and here is an example using a value stock you may want to own today:

Let’s say you want to buy 200 shares of BAC (Bank of America Corp) today at $15.78. Using Phil’s Buy/Write Strategy, you purchase 100 shares of BAC today, June 17, 2011, and simultaneously sell options on the stock: (NOTE: One option contract is equal to 100 shares.)

One Jan 2011 $15 call for $2.50
One Jan 2011 $15 put for $1.62

These two option contracts reduce your net cost basis to just $11.66 ($15.78-$2.50-$1.62), and you have taken on two obligations dependent on one of the following scenario taking place:

Scenario #1: BAC is above $15 on Jan 21, 2011.

The call option you sold will be exercised by the person who bought it, and your 100 BAC shares called away at $15. (Your put option will expire worthless to the holder.) The profit on that trade would be $3.52 per share against our net outlay of $11.66, a 31% profit in 7 months.

Scenario #2: BAC is below $15 on Jan 21, 2011.

The put option you sold will be exercised by the person who bought it, and you will be required to buy an additional 100 shares of BAC at $15. (Your call option will expire worthless to the holder.)

Yes, you will have to pay $15 for 100 additional shares of BAC, regardless of its current price, but remember, you got your original 100 shares at net $11.66 (considering the two options you sold), so 100 more shares at $15/share would give you a new net basis of $13.28 -which is 15.8% lower than the current price.

In either scenario, you have acquired or controlled the 200 shares of BAC you wanted to purchase — and you got them at a10-20% discount using Phil’s Buy/Write Strategy.

Recall that sound investing principles start with finding fundamentally sound stocks which are undervalued, have good growth, are optionable, and which you don’t mind owning long term.
In short, if you think BAC is a relatively good deal at $15.60 – why not commit to buying it for $13.16 instead?

Let’s take the BAC example a step further.

In Scenario #2, when January 21, 2011 rolls around, you own 200 shares of BAC, at a basis of $13.16. You can continue to sell calls against the stock.

Let’s say BAC falls all the way to $12 (down 30%), and your net basis is $13.16. You can still sell $15 calls for about $0.25 a month. That’s $3 per year (per share) against your $13.16 (22.8% annual). Plus, you’ll make an additional $1.84/share if BAC closes above $15 on any option expiration date.

Learning to use options effectively can enhance your investing life!

We identify dozens of trades like this every week at Phil’s Stock World. While you can do this with any stock, we’re able to identify unique option opportunities that make certain stocks a little more favorable than others — and we can teach you to do it, too.

At this point you may be saying to yourself: ”If I can learn to buy all my stocks for 15% to 20% discounts, I bet my trading performance will improve.”

That’s exactly what hedge fund managers do, and there’s no reason you can’t learn to do it as well!

We have featured hundreds of these opportunities to members of Phil’s Stock World, and in this scary and volatile market, this strategy is one of the best ways to capitalize on volatility while hedging the risk on your upside strategies.

If the market ends up flat-lining, however, you will be positioned in stocks at good prices that can generate a very reasonable monthly income — which will keep you flexible in a challenging market!

Note: You can try the PSW Report Membership Package ($23/month) for a 20% introductory discount (or one of our other option trading services). Phil’s Stock World Report features some of these trades weekly. If you want live alerts of trade ideas as we identify them, or want to view our daily trading chat live, then check out a Basic or Premium Membership.

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