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The basic premise of investing is to buy low and sell high. It's a good rule of thumb, but it's hard to implement in the real world.
In fact, it's hard to make above-average gains in the stock market by simply buying and selling stocks. Over the past 30 years, just matching the market would have made you about 8% annually on average. And you would have had no built-in downside protection in corrections or bear markets.
The best way to beat the market is to utilize leverage through options. For example, a simple call option allows you to control 100 shares of a stock for a minimal cost. If the stock falls in value, you cannot lose more than you paid for the option. By controlling a large amount of stock for a relatively low upfront cost, investors can ramp up gains in a safe and effective way.
Today's trade in GameStop (NYSE: GME) will cost you $325 or less and could return more than 200% in just a few months.
This well-known gaming and electronics retailer has struggled so far in 2014, down 18% year to date. But with the holidays quickly approaching, shares could get a boost.
GameStop is preparing for a strong holiday season with the company saying it plans to almost double its seasonal hiring to 25,000 workers.
Along with a number of hyped-up new releases for the Xbox One and PlayStation 4, GameStop expects to benefit from customers looking to trade in their smartphones in order to upgrade to Apple's (NASDAQ: AAPL) iPhone 6.
In a push for customers, the company also announced that it will offer expanded layaway offerings, including next-generation videogame consoles and tablets. And it said it plans to offer more generous financing terms for its store credit cards.
Long-term EPS growth is expected to exceed 15% a year on average, while the stock trades at about 9 times next year's earnings estimates.
A stock's PEG ratio compares its P/E ratio to its earnings growth rate, with 1 being considered fair value. With a PEG ratio of just 0.58, GME looks undervalued.
The stock recently crossed above its 200-day moving average on higher-than-average volume, suggesting that upward momentum is picking up.
Currently, almost 35% of the company's shares are held short. If buyers are cheered by strong holiday sales, the shorts may be forced to cover, resulting in a short squeeze that could catapult the stock back toward its 52-week highs.
Based on expected EPS of $4.39 for next year and a current P/E of 12, GME should be fairly valued at about $52 per share.
With a call option, we can take advantage of this potential upside while limiting our losses in the event holiday sales disappoint or the general market correction continues.
I like the GME Jan 41 Calls for a limit price of $3.25.
The breakeven point is $44.25, the $41 strike price plus $3.25 in option premium.
The maximum possible loss is the cost to initiate the trade, while the upside is theoretically unlimited. If GME hits my $52 price target, the call option will be worth at least $11 -- a 238% gain.
Compare this with simply buying 100 shares of the stock. A straight stock purchase would cost about $4,060 compared with just $325 for the call option. And if GME runs to $52, shareholders will only make a 27% return. Call options are a great way to leverage gains without putting an excess of capital at risk.
Recommended Trade Setup:
-- Buy GME Jan 41 Calls for $3.25 or less
-- Set price target at $11 for a potential 238% gain in three months
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