5 'Blood In The Streets' Option Spreads

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 |  Includes: AFL, ANRZQ, MOS, RIG, X
by: Phil Fragasso

While the S&P 500 closed 2011 with a modest total return of 2%, many equities were pummeled during the year. And if you're a contrarian like me and adhere to the advice of Baron Rothschild, the 18th century British banker who famously declared that "The time to buy is when there's blood in the streets," then opportunities abound for speculative option plays.

Please keep in mind, however, that "speculative" is the operative word. I'm a believer that the stock market is not the efficient exchange that some would argue. Rather, stocks get bid up too high and beaten down too low - and that excess creates opportunities even if you don't manage to buy at the precise low and sell at the precise high. And since we're speculating, I prefer to use option spreads to reduce my cost basis and dramatically lever the upside (albeit with a limit on maximum gain).

Here are five stocks that offer the kind of risk-reward I look for:

  • Aflac (NYSE:AFL) was down 23% in 2011 due to concerns related to the Japanese earthquake and the EuroZone financial crisis. With a yield of 2.9% and a forward PE of 6.94, I see little downside from current levels and good opportunity for the stock to revisit its $59 high.
  • Alpha Natural (ANR) got crushed to the tune of a 66% loss in 2011. The reasons for the huge loss include the suspect acquisition of Massey Energy, concerns about US regulatory pressure on coal, and slowing demand from emerging markets. Nonetheless, improving margins and cost-savings from the Massey acquisition and a forward PE of 10 should generate outsized gains even if the stock comes nowhere near its 52-week high of $68.
  • Mosaic (NYSE:MOS) lost 34% of its value in 2011 and remains 41% below in 52-week high. Some of this loss can be attributed to the overhang associated with the spinoff from Cargill, concerns about global demand, and pricing pressures. I would offset those concerns with strong fertilizer fundamentals for the foreseeable future, and the frequently mentioned possibility of a takeover now that Cargill is out of the picture.
  • Transocean (NYSE:RIG) dropped 45% in 2011 due largely to continued concerns related to Gulf oil spill liability and a significant slowdown in offshore drilling. As the world's largest offshore drilling rig contractor, however, Transocean is well positioned to reap the benefits of the increasing global demand for oil and gas. With a yield of 8% and estimated earnings growth of 15% annually for the next 3-5 years, the stock offers significant upside potential.
  • US Steel (NYSE:X) was down 55% in 2011 due to the same global-demand issues that affected all of the infrastructure-related commodities. Looking ahead, however, the worst appears to be in the rear-view mirror and a pick-up in demand will be accompanied by a decline in pension/healthcare benefits as well as an uptick in pricing power due to consolidation of the steel industry.

The table that follows indicates how I've structured the spreads. In each case, the long position has a near-the-money strike (which, in my opinion, reduces the overall risk of the trade) and the short strike is 11% to 30% higher. Expiration dates range from April to June. Here's how to read the table using AFL as an example. On Friday January 6, AFL closed at $44.24. You could have bought a May 2012 call with a strike price of $45 for $3.25, and sold a $50 call for $1.30. Your net cost (and maximum loss) would be $1.95. Your maximum gain would be $3.05 (proceeds of $5.00 minus cost of $1.95) or 156.4%.

And please keep in mind that all numbers would be reduced by transaction costs.

Click to enlarge

Click to enlarge

Disclosure: I am long AFL, ANR, MOS, RIG, X.