Options are a core part of my investment strategy. I consistently use slightly out of the money bull put spreads on stocks I believe are undervalued to pick up the shares at a lower entry points and/or pick up premium income. I establish the majority of my long positions with this method. To a much lesser extent, I use out of the money bull call spreads to establish some speculative positions on stocks I think may head higher in the near term. I like this approach as I can structure them so they return three or four times my investment if I am right and they have limited and definable downside if I am wrong.
I have had a decent run using this strategy recently scoring better than a double on Research in Motion (RIMM) before I decided to go short on the same equity earlier in the week. It also looks like I will do better than a triple on my EMC Corp (EMC) play. On the downside it looks like my December 560/570 bull call spread on Apple (AAPL) will come up a loser unless the shares stage a huge rally over the next two trading sessions. One thing I like about this strategy is it is very profitable over time if you only are right 30% to 40% of a time. I also like to have a theme for these types of speculative plays. For EMC and AAPL, I initiated these positions during the sell-off after the election when fiscal cliff fears got overblown. For RIMM, the stock looked like it had good momentum with its upcoming BB10 launch and the shares had been beaten down for so long.
The theme I am playing today is with stocks that have had huge runs over the last few years but have sold off recently among some setbacks, but who have probably pull backed more than they normally would as investors have decided to take long term gains on these holdings to avoid higher capital gains taxes in 2013. It is hard to quantify how much selling has been driven by this factor, but it is likely to have been significant. If my thesis is correct, they should have good pops when the New Year begins after those headwinds are gone. My new positions are as follows:
Express Scripts Holding Company (ESRX) is a large pharmacy benefit management (PBM) that provides services in North America. The stock is down some $11 from its highs earlier in the quarter. The stock sells for less than 13x forward earnings, a discount to its five year average (17.5). Express Scripts could be a big beneficiary of Obamacare and the stock has been a stellar performer since the market bottomed in March 2009 with a gain of almost 150% even with its recent fall. Over a decade it is up over 600%.
I am willing to make a small bet that the stock can recover half its recent losses once 2013 begins. I bought a bull call spread using the Jan 55/60 call pair for a net debit of 80 cents. My maximum gain will be if the stock climbs to $60 or above in the next month and I net $4.20. My maximum loss is limited to my 80 cent investment and I like the 5 to 1 potential.
I also willing to bet on Apple again as I believe it deeply undervalued at just over 9x forward earnings, given it is still showing significant growth and has over 20% of its market capitalization in net cash. The shares are still up an incredible 535% since the financial crisis low and more than 3500% over the last decade. I am going to bet that just 25% of its recent 170 point decline from its peak in September is capital gain selling related. I am going to play the same bull call spread (560/570) that I tried for December, but this time for the January 19th option expiration date. This pair cost me $2.50 earlier this morning. If Apple pops back over $570 a share in the new year it will provide a triple on my investment, a risk/reward I like on these oversold shares.
Additional disclosure: I am also short RIMM via bear call spreads as well.