In spite of the negative rhetoric for the last two weeks, the indices just made new all-time highs. This should be to no surprise because the macroeconomic conditions warrant it. Skeptics have focused only on the negative perception. Whereas the facts support more upside. The U.S. dug itself out of a deep instant hole by spending. The government is throwing trillions of dollars into the economy to reboot it. Therefore, the opportunities are in the stocks to buy, not short. The bears are falling into short traps because machines are buying every dip.
Ask friends and family about the size of the check they just got from this administration. And they did not do a means testing first. They even sent stimulus to people who don’t need it. Luckily this means that the money will be spent and companies that serve the U.S. will prosper. The right thing to do is to buy stocks in this environment, not sell them. The dips were all buying opportunities, alas the experts scared a lot of retail investors out.
Conviction is low and part of the problem is that good stocks now carry a high ticket price. This makes them unattainable for a lot of investors. Luckily, the options markets provide alternatives to circumvent that hurdle. Perception is that options are more dangerous than stocks. This is false because it’s an incomplete statement. Options move faster than stocks so they “can” be more dangerous. Using them responsibly is far less dangerous because they offer leverage, so smaller out-of-pocket risk.
This means I can risk a smaller amount to accomplish bigger things. Risking less is by definition less dangerous. Buying 100 shares of a stock that is $1,000 costs $100,000 up front. This provides no room for error and losses accumulate immediately if it falls. With options, investors can drastically reduce the out-of-pocket expense to participate with 100 shares. Up-front cost is a fraction of that amount.
The risk comes from investor psyche. The relatively small upfront cost sometimes causes investors to forego rules. Therein lies the potential pitfall options carry. Leverage means fast profits if the thesis works out, but also brings fast losses if not. Because it’s cheap doesn’t mean I don’t have to do homework. A proper thesis is an absolute must when using options, even more so than buying equities.
It all starts with homework. Today, we assume that 2021 will have good economic economic conditions. First, because the reopening process is going very well. Secondly, the inoculation process in the U.S. is successful. Lastly but not least, there are trillions of dollars handed down to us from the government. These are tailwinds that the bears just cannot fight. They will need a new Black swan that is not already in the headlines. Three stocks to buy using options are:
Stocks to Buy Using Options: Amazon (AMZN)
I am a big fan of Amazon because they are the perpetual startup company. This makes them the picture-perfect growth stock to own. The critics fought it for decades because it was spending too much. Little did they know that they were building an empire. You cannot deliver growth like that while pinching pennies.
Now its valuation is the cheapest among mega-cap stocks. Yes, you read that right: Amazon stock’s price-to-sales is only 4. Tesla (NASDAQ:TSLA) is almost six times more expensive. It is also roughly two times cheaper than Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB and Alphabet (NASDAQ:GOOGL,NASDAQ:GOOG). The owners of the stock are very realistic with their expectations.
AMZN carries a high ticket price, which make it seem expensive. But you get what you pay for, after all they doubled their net income in under two years. The problem is that not many investors can afford to buy 100 shares and risk $316,000. Using options requires us to spend only one-tenth that amount and be long through September.
While the out-of-pocket risk is smaller, it does carry additional pitfalls. Time is a factor whereas with actual shares it’s not. Therefore, investors who buy the call need to place a tight stop. If this stock falls below the March 5 lows, I should get out and reset another entry. This step is important because of the negative time factor. Another way of using options is to sell a put to flip the time from foe to friend.
Instead of buying upside hope, I sell a put, which reserves my stock purchase but way cheaper. For this I collect a premium so in essence I get paid to potentially be long AMZN stock. For example, I can sell the September $2,400 AMZN put and collect about $2,800 now. In this case time is my friend. Even if the stock falls 40%, I break even. If AMZN stays above $2400, then I’ve created income out of thin air. The worst case scenario means that I own shares at 25% discount from here. When I sell a put, I collect my profits up front and I don’t need a rally to win. The fundamentals of this company are beyond reproach so buying it cheaper is a good thing.
Palantir stock is one of my favorites of the past six months. This is a relatively new issue on Wall Street but of an older company. Therefore, they already have an existing business and it’s growing. Moreover, the environment now is more conducive to its prosperity so growth should accelerate.
The digital revolution went into hyper-gear because of the pandemic. Companies will be generating more data at a faster pace so they will need help using it. Palantir offers such solutions to the private sector and the government. Artificial intelligence allows us to make on-the-fly decisions going forward. Just like humans can leverage the power of machine thinking, investors use options to leverage dollars.
Corporations are busy building systems to collect, process and store data. Palantir is there to help them manage and use it. The stock has a low ticket price so buying 100 shares is attainable. But this also makes it a good candidate for buy-write strategy. Instead of spending $23,000 to own 1,000 shares, I can buy 10 January 2022 $25 PLTR calls for only $5,000. This reserves me the right to buy the shares at $25 even if it is much higher by then.
In addition, I would intermittently write calls against them to further lower my entry price. This method has other names like the covered call strategy, call calendar or diagonal. As long as I own a call option out in time, I can sell closer calls against it. Regardless of nomenclature, essentially I am buying an asset – the 2022 January call – and I’m putting it to work immediately. Selling puts also works here and I like them both equally.
General Electric (GE)
General Electric is the third pick today and this is a rinse-and-repeat strategy for me. Months ago, when the stock was still under $7, I wrote about getting long the stock. That trade proved very profitable and I’m essentially repeating the process for next year.
GE went through a hideous stretch where management almost broke it. They made one mistake after another until they ran it into the ground. The current team has turned the ship around. They have since fixed mistakes, streamlined its businesses and are in the process of reducing debt. They created a lean, mean machine to revert to growth.
Shrinking to grow was the right strategy and they had to shed all the fat. They are now in four very profitable segments, so they positioned the company very well for the next few years. Specifically, I want to chase GE stock on the breakout from $15 per share. It should bring about a 40% rally into the end of the year. To capture that, I can buy a leap call. Specifically, I choose the GE 2022 January $15 call. The complete out-of-pocket expense is $1.25 per contract, which would be my maximum risk.
Fundamentally, GE stock has a reasonable 22 P/E and only a 2.5 price-to-sales. It can easily accommodate a spike in price without raising many eyebrows. The technical aspect of the setup makes it perfect to use leverage with options instead of equity. Owning the stock also works but options provide bigger bang for the buck.
There are a few important rules for successful options trading. The first we’ve already noted the need for having a solid thesis. Buying upside potential willy-nilly can cause tremendous damage over time. Another important pitfall to avoid is selling puts in stocks I don’t intend to buy. If the market crashes, doing so can wreck an account. If I cannot afford to buy 100 shares of Amazon, I should never sell a naked put in it.
On the date of publication, Nicolas Chahine did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Nicolas Chahine is the managing director of SellSpreads.com.