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Many investors are familiar with the market catch-phrase, 'Sell in May and go away'. Many investors have taken heed of this over the last five years as more fear and apprehension have crept into all markets due to poor global economics and the sweeping effect of geopolitical events.

However, whether one is bullish or bearish, there are several opportunities during the summer months for both the large and small investor. If an investor is concerned about the summer market doldrums but also concerned about missed opportunities, one could consider opening a long stock position with a protective put option. This option investment strategy allows the investor to take advantage of upside gains, while at the same time guaranteeing a limited loss percentage even if the stock drops to $0.01 per share. But what type of stocks should an investor look for?

Low Cost - Good Fundamentals

As a general rule when the market shows weakness investors will gravitate towards large cap, dividend paying stocks or towards commodities such as gold and silver. As we know, this can be a boon to the lower priced mining stocks. Many of these lower priced mining stocks have been depressed over the last few months, but have recovered in the last 30 days. The gold stocks looked particularly appealing because of talk of quantitative easing by the FED which would be bullish for the sector.

When looking to open a position on a lower priced stock we must still make sure that the underlying security has good fundamental criteria. Some basic criteria one might consider is to look for low priced stocks that have a double digit % EPSG (% Earnings per Share Growth), a reasonable P/E Ratio (Price/Earnings), a good average stock volume (to avoid stocks that might be more prone to negative price fluctuations) and it never hurts to look for stocks that are in an uptrend.

At the same time we want to identify put options that will keep our risks to single digit percentages and insure those potential stock positions through the summer months. We entered this criteria into the patented PowerOptions SmartSearchXL tool:

Stock Criteria

Stock Price between $5.00 and $15.00 per share

% EPSG greater than 10

Price / Earnings Ratio between 0 and 40

Average Stock Volume greater than 500,000 shares

Stock Price greater than SMA 50

Put Option Criteria

Put expiration greater than 150 days out in time

Put Option less than 20% In-the-Money

Open Interest greater than 10

% Maximum Risk less than 8.5%

The results were sorted by the highest % EPSG. On Wednesday, June 20th 2012 these were the top 5 results of that criteria:

(click to enlarge)

Although Gold Fields Ltd. (NYSE:GFI), Iamgold Corp. (NYSE:IAG), and Eldorado Gold Corp. (NYSE:EGO) have a lower percentage at risk than New Gold Inc. (NYSEMKT:NGD), we were drawn to the high %EPSG and lower monetary at risk amount of $0.97 per share. The lower at risk amount is also due to the shorter expiration time frame (November as opposed to January or December).

Position Specifics:

Before we get into further discussion of the potential benefits and concerns of the potential NGD Married Put position, let's look at the specifics of the Married Put Trade:

Action:

Buy shares of New Gold Corp @$9.97 ($997.00 per 100 shares)

Buy 2012 NOV 11 Strike Put @$2.00 ($200.00 per 1 contract)

Total Amount Invested = $11.97 ($1,197.00 per 100 shares)

Guaranteed by Put Option = -$11.00 ($1,100 per 100 shares)

Max. Risk on Position = $ 0.97, or 8.1% ($97.00 /100 shares)

Maximum Profit on Position = Infinite

(click to enlarge)

Let's consider what this Profit and Loss Chart means:

  • Even if the stock collapses to $1.00 or even $0.00 per share we cannot lose more than $0.97 per share, or 8.1% of our invested capital

  • Our upside profit potential is unlimited

  • The position is insured to November expiration, or roughly 150 days out in time

  • Although the total position cost is $11.97, we do not need NGD to be trading at $11.97 per share to realize a profit. The curved red line on the Profit and Loss chart shows the theoretical gain or loss of the NGD Married Put on September 4th, half-way between now and expiration. The put option will not decline 1:1 with an increase in the stock price, ergo a profit can be realized prior to expiration before the stock reaches the cost basis of $11.97

  • As the stock moves up, down or stagnates we will look to apply other options trades to lower the initial at risk amount and potentially earn extra income.

Further Research:

(click to enlarge)

New Gold Inc. matched the initial stock criteria and a protective put option was identified that guarantees an exit so no more than 8.1% of the invested capital is at risk. This is much safer than a stop loss which can be violated and result in significant losses. We are still able to take advantage of unlimited upside profit potential and have the opportunity to use other options trades to lower the initial risk and generate income.

New Gold Inc. also recently entered into a new debt agreement which allows them to pay a dividend. Although the company has yet to declare if they will pay dividends to stock owners, a dividend paid before November expiration would further reduce the initial at risk amount.

There is some concern for New Gold Inc. regarding the El Morro mining project in Chile. The Chilean Supreme Court recently suspended the permits for the project based on environmental concerns. Goldcorp Inc. (NYSE:GG) has a 70 percent stake in the El Morro project, with New Gold Inc. holding a 30 percent stake. Shortly after the announcement, New Gold Inc. released a statement that the two companies are working with the environmental agency closely to quickly "address any perceived deficiencies regarding the consultation or compensation of indigenous people in the area of the El Morro project".

This concern reinforces the necessity of insuring any position on New Gold Inc. and apply proper money management, as opposed to using a leveraged option investment that could result in over trading and significant losses. The Married Put setup forces an investor into a position where upside gains are not capped and the risks are limited to only a small amount of the invested capital.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NGD over the next 72 hours.

Source: A Protected Gamble: Bullish On New Gold Inc.