Indeed, by several fundamental measures, stocks are trading at a premium to their historical averages. Particularly in the United States.
But in an ultralow interest rate world, in which savers earn next to nothing on their cash, that’s to be expected.
And following President Trump’s stunning defeat over Hillary Clinton, stocks got a lot pricier.
Many folks reading this column might think the boat has already sailed on the “Trump Rally” in stocks.
Free Reports:
I assure you: The rally is just getting started.
As I mentioned on Friday, historical data indicate that the market should continue its upward momentum in the coming months.
And below, senior analyst Jonathan Rodriguez reveals a little-known way to generate big-time returns on “pricey” stocks and reduce risk at the same time.
But U.S. stocks have soared in a bull market for more than seven years. It ranks as the second-longest bull on record. And valuations have become pretty heady.
Yet if you’re on the sidelines waiting for a pullback to buy stock… you’re missing out.
The S&P 500 has gained 11% since Election Day, and the index hasn’t dropped by more than 1% since October.
Still on the fence?
What if I told you that there’s a way to sidestep buying pricey stocks, pull exponentially higher gains out of the market and reduce your risk — all at the same time?
Well, that’s exactly what options allow you to do.
Options are perhaps the greatest — yet misunderstood — wealth-building tools available to investors today.
Of course, you might have heard that options are risky or difficult to understand.
Neither could be further from the truth.
And over the next few weeks, I’m going to show you just how powerful — and simple — options can be.
So let’s go over some basics…
Options 101: Breaking Down the Basics
There are two types of options: calls and puts.
Today, we’re going to talk about call options.
A call is simply a contract that gives an investor the right, but not the obligation, to buy 100 shares of stock at a predetermined price on a future date.
The price is known as the strike price, and the future date is known as the expiration date.
Easy enough, but why would an investor purchase a call option over shares of stock?
For one, calls are a whole lot cheaper — especially when volatility in the market is low, like it is now.
An option often trades at pennies on the dollar compared with the underlying shares.
Call options also move a lot faster than stocks, so you can compress your time horizon for profits significantly.
In addition, your downside is limited to the amount of money you paid for the calls — so you end up risking much less than you would buying shares outright.
Let’s take a look at an example…
Let’s say that you think the price of oil is going to rise by the end of the year — and, as a result, lift oil stocks.
I like Chevron Corp. (CVX) as a proxy for oil. It’s one of America’s largest integrated oil companies. And it’s a very liquid company with a deep option chain.
The stock has rebounded nicely off its 2016 low but still trades at more than 100 times trailing earnings — well above the stock’s five-year average of 11.8.
In other words, the stock is by no means cheap.
But let’s say you think Chevron will rise to $125 by year-end.
Buying the stock at current prices would cost you about $11,200 before fees. You’d net a gain of 12% if you’re right about your forecast.
Or you could go with a call option to purchase 100 shares. You’d choose the option with a strike price of $125 and a Jan. 19, 2018, expiration date. That would cost you $395 ($3.95 option price X 100 shares).
That’s leverage of about 30-to-1.
Ultimately, your option breaks even if the underlying shares hit $123.90 by expiration.
And if the stock hits your $125 price target, you’ll book a profit of 52% on the call.
So buying the call option does three things:
Best of all, you avoid paying the hefty earnings premium on the shares.
Incredible, right?
Next week, I’ll show you how to use put options to capture downside momentum. Stay tuned.
On the hunt,
Jonathan Rodriguez
Senior Analyst, Wall Street Daily
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