Over the long term, value stocks tend to be winners. There are a number of ways to define value. My preferred approach is to use the PEG ratio. This metric compares the price-to-earnings (P/E) ratio to the earnings growth rate. A PEG ratio of 1 indicates the P/E ratio is equal to the earnings growth rate and the stock is fairly valued. So, value stocks have PEG ratios less than 1.
Value investors generally need patience in order to succeed. It can take time for the stock to deliver gains for a variety of reasons, but within a few years, value investing usually delivers results.
Options are usually thought of as short-term trading tools, but there are some options that expire in years rather than weeks or months. These options are called LEAPS, which stands for Long-Term Equity Anticipation Securities. Currently, there are now LEAPS available that will expire in January 2015 and January 2016.
Although they are long-term investments, LEAPS are the same as traditional options in every other way. Buying LEAPS allows you to participate in market gains with limited risk.
A call option gives the buyer the right to buy 100 shares of stock at a predetermined price (the strike price) at any time before expiration. The value of a call option increases as the price of the underlying stock increases. One advantage of call options is that they cost less than the stock. This means traders can capture a larger percentage gain when the stock trades higher.
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However, many investors point out that options carry a greater degree of risk. And some traders avoid buying options because they do not receive any dividends.
To maximize the potential gains of options, we could limit our buying to non-dividend-paying stocks. We could also limit risk by only buying call options on large-cap stocks, which have demonstrated that they can survive the ups and downs of a business cycle. Another risk management tool is to buy call options on value stocks, which I define as stocks trading with a PEG ratio under 1.
Micron Technology (MU) looks like a good candidate for this call option strategy. The computer memory maker lost more than 95% of its value after the 2000 market top. Unlike many stocks from that era, MU has survived.
On the monthly chart, we can see that MU formed a base over the past 10 years and seems to be breaking out to the upside.
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The stock is currently trading at 8.2 times next year's expected earnings. Analysts are optimistic and expect earnings growth of 18% a year in the next five years. The PEG ratio is 0.45. Since a PEG ratio of 1 represents fair value, this indicator shows that MU could double in price, which gives us a price target of about $34.
A call option expiring in January 2016 with an exercise price of $5 is trading for about $12.20. It is profitable if MU trades above $17.20, which is only about 1.5% above the recent stock price. If MU reaches the price target of $34, this option would be worth at least $29. The potential gain on the stock is 100%, while the call option offers a potential gain of 140%.
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Less expensive options are available, but they require larger price moves before becoming profitable. For example, the $15 call option sells for about $5.25 and is profitable only if MU moves above $20.25.
Buying a call option also carries less risk than the stock. Traders can lose only the amount paid for the option, and a stop-loss can be used to limit losses.
Recommended Trade Setup:
-- Buy MU Jan 2016 5 Calls up to $13
-- Set stop-loss at $9
-- Set initial price target at $29 for a potential 123% in 27 months