The best stocks to buy are those that are undervalued. And when you combine an undervalued stock with an undervalued long-term option contract, or LEAP, your chance of securing a nice profit is much greater.
I like to use a company’s earnings estimates to help determine the forward value of the company’s shares and, in turn, their options. By multiplying the consensus earnings estimate for the stock by its current P/E (price-to-earnings ratio), you can arrive at a projected stock price when its LEAPS expire. (LEAPS are options that allow you to buy up to two and a half years worth of time.)
If this price projection is above the break even stock price (i.e., the strike price of the option plus the cost to buy the option), then you have found an undervalued LEAP. In my opinion, nothing beats buying an undervalued option, because not only are you getting it on sale, but you’re also able to enjoy even bigger profits than other investors who come later to the party and pay more to get in on the same trade.
If you want to be conservative in projecting the price of a stock before your option expires, you can use the lowest earnings estimate for your price projection. If you want to be more aggressive, you can use higher estimates than the analysts’ consensus.
Let me give you a historical example to illustrate how this strategy works.
A few years ago I put this strategy into action with a Pfizer (PFE) Jan 32.50 Call that was selling for $2.80 ($280 per contract). At the time, the stock was trading at $31. The LEAP’s breakeven stock price (strike price plus option price) was $35.30.
To run a quick fundamental analysis on this position I checked Pfizer’s earnings estimates for the nearest timeframe before the LEAP expired. At that time, the consensus earnings estimate of professionals who follow the stock and its industry every day was $2.08 per share.
To find my stock price estimate for the shares, I multiplied the consensus earnings estimate by the stock’s P/E, which was 31 at the time. So, my price estimate for Pfizer one month prior to the LEAP’s expiration date was $64.48 ($2.08 multiplied by 31).
This was well above the LEAP’s break even stock price of $35.30. In fact, it was estimating a price gain of more than 1,000% by the LEAP. (A stock price of $64.48 puts the LEAP over $31 in-the-money, giving the option a value of at least $31.)
Now, that struck me as a little too good to be true. So, I also estimated the future LEAP value using Pfizer’s then industry average P/E of 21. This lower value gave me an average stock price of $43, implying a potential gain of 275% for the long-term call options.
Taking the calculation one step further, I used Pfizer’s lowest average earnings estimate at the time ($1.74), combined with the industry average P/E of 21. This gave me a “worst-case” December stock price of $36.50, still above the LEAP’s breakeven stock price, and an implied LEAP value of $4, or a gain of 42%.
Of course, earnings estimates can change, and P/E ratios can compress. Also, we all know now that any stock’s price is capable of being pulled down by a strong bear market undercurrent. That being said, the principle of valuing LEAPS by using some simple fundamental analysis on the underlying stock can help move the odds of profit more firmly in your favor.
This strategy can also help you ride out some of the storms you will invariably encounter during the long-term life of your LEAPS.
So, if you want to make the LEAP toward big profits, why not put the power of LEAPS and your own powers of analysis, to work for you?
Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.