Getting paid to buy options...

Getting paid to buy options... Another regression chart... A glutton for punishment...

I want to start this Friday Digest by talking about a kind of trading that 97% of our readers should never attempt. It's risky. It's expensive. It's complicated. And it requires a lot of experience to do well. So why would I bother talking about it? Why would you be interested?

Let's me explain...

Interest rates on U.S. Treasury bonds are hovering around 1% and the spreads between these low rates and almost every other form of fixed-income is extremely compressed. So it's nearly impossible for average investors to make money safely. When I say "safely," I mean without putting principal at significant risk.

For most of the last 30 years, simply buying a mix of investment-grade corporate debt would earn you between 8% and 12% a year without putting your principal at much risk. Even yields on municipal bonds ran about 6%-8%. Unfortunately for us, the Federal Reserve has decided to join the government's war on the middle class. They're intentionally making it impossible for you to safely invest your money and earn a reasonable return. They've manipulated interest rates lower. And investors searching for yield have driven rates on all forms of fixed income down to stupefying levels.

As a result, you have very few low-risk ways of making a reasonable return on your capital. All of the remaining strategies require at least some principal risk. We've covered these ideas several times in our pages: distressed corporate debt (which can be safe, if you're diversified and you buy at the right price), dividend growing, blue-chip stocks (like Wal-Mart or Coca-Cola), mortgage REITs (like Annaly and Two Harbors), and conservative options trading (selling puts or covered calls on blue-chip stocks).

Following these strategies, you can still safely earn 10%-25% per year – with very little principal risk. Unfortunately, these strategies all require a pretty sophisticated knowledge of the markets and a fair amount of discipline.

There's one other, far better way to generate income in today's markets. I've never written about this approach because it's a bad idea for most people. Nevertheless, I want to introduce it to you today. I know you're unlikely to try this kind of trading – but if our roles were reversed, I'd want you to share this with me.

That's the whole point of these Friday Digests. I know I can't really teach you anything about finance or trading. You have to want to learn. But... I'd bet that most of our subscribers have never considered or even heard of this approach before. And it's awfully hard to learn something if you've never heard of it...

I'm talking about advanced options trading – things like spreads and collars. Now, before your eyes glaze over... give me just five minutes on the topic. I'm not going to bog you down in all of the jargon or in the specifics of these trading strategies. They are very complex. They require a detailed analysis of the underlying stock and the current pricing of the options that trade around it. The best way to learn a bit about this kind of trading is to simply look at one such opportunity in detail – a real-life example. I want to show you how I think about these situations and what trades are possible. My hope is that this gets you to start thinking about what's possible with your own trading.

Superinvestor Warren Buffett says if he were still managing a small amount of money ($10 million or less), he could make 50% a year simply doing "arbitrage." Arbitrage – which in this case involves trading stocks around mergers and acquisitions – got a bad name during the 1980s. Back then, insider traders like Ivan Boesky paid off crooked lawyers to tell them about upcoming deals. But you don't have to break the law to make a lot of money doing arbitrage. All you have to do is keep your ear to the ground and follow publicly announced merger and acquisition news.

To use a current example... Chicago Bridge & Iron (CBI) announced this week it would spend $3 billion in a 90% cash deal to acquire power-plant builder Shaw Group. CBI is offering to pay $41 in cash and 0.12883 shares of its stock, in exchange for shares of Shaw.

[Editor's note: CBI has been in the Stansberry's Investment Advisory portfolio since Porter recommended it in the June issue. Subscribers are essentially breakeven on the position, up less than 1%. Porter published a full analysis of the announced merger, which subscribers can read here.]

With CBI trading around $35, the offer is equal to $45.50 in total compensation to Shaw Group shareholders. (That's $41 in cash and $4.50 in stock.) All it takes to figure this out is basic math (0.12883 times the current CBI share price). It's not hard.

Currently, the shares of Shaw Group are trading for $39. It should take about six months for this deal to close. Buying Shaw shares and selling CBI shares would allow you to net the difference between $39 and $45.50 – $6.50, as the spread between the two shares will be eliminated when the deal closes. Depending on your margin requirements, I'd expect this to make you around 14% on your capital at risk. That's a great return for a six-month period.

The key risk you would face with this strategy is the chance the deal falls through. But CBI is offering 90% of the deal in cash... so it's very likely to close. You wouldn't be taking on much risk with this trade.

You could also use a simple options trade to participate in the opportunity... We know Shaw Group's stock should be worth at least $41 per share when the deal closes. And it is most likely to be trading around $45.

Right now, you can sell a put option on Shaw Group's stock for $4.26 with a "strike price" of $40. This put won't expire until January 2013, when the deal will have likely closed.

Remember, selling a put would require you to buy shares of the stock for the strike (in this case, $40), if the stock trades for that price or less by the time they expire (in this example, January 2013).

So if the final CBI-Shaw deal values Shaw shares at anything more than $40... this put will expire worthless. You'll keep the $4.26. Measured against capital at risk, that's a return of just more than 10%, or roughly 20% annualized. That's not bad, and it's a good way for well-capitalized investors to generate income. And the trade becomes more lucrative as CBI's share price rises.

The best way, however, to play this arbitrage is a bit more complicated and riskier. Right now, investors are bearish on the shares of the acquiring company, CBI. They are worried that this acquisition won't go smoothly and CBI is paying too much. I've looked carefully at the deal, and I disagree...

Risk-tolerant investors could simply buy shares of CBI right now. The stock has fallen about 15% since the deal was announced. I believe this represents a good opportunity to buy the stock, which I expect to double in price over the next three to five years.

If you wanted to take this kind of bullish position, sell the same Shaw put with a $40 strike price that I described above... and use the $4.26 premium to buy a call option on CBI. The $35 call options on CBI expiring in January 2013 are selling for around $3.70. If you did this trade, you'd receive a credit in your account of $0.56. It wouldn't require any direct capital. You'd actually be paid to put the position on. That net credit would represent a return of about 1.4% on capital at risk (your potential obligation to buy shares of Shaw at $40 each).

That's nearly 3% annually. That's not great – but it beats sticking your money in the bank. Meanwhile, you're positioning yourself to profit from CBI's stock if it trades for more than $35 a share.

Let's say CBI closes at $40 a share in January 2013. Holding a call gives you the right (but not the obligation) to buy CBI shares at the options strike price (in this example, $35). So in this case, you could buy those shares at a discount to the market price and immediately sell them, pocketing the difference... in this scenario, $5.

And you'd keep your $0.56 initial credit. So you'd earn $5.56 on $40 at risk (14%) in fewer than six months. And you did it using other people's capital. (You bought the call using cash you received from selling the Shaw put.)

If the market gets a bit more bullish... perhaps CBI closes in January 2013 at $47 – its current 52-week high. Under that scenario, you'd make $12.56 on each $40 at risk, a 26% return in less than six months. That's an annualized return, using other people's capital, of more than 40%.

Of course, this risk is CBI shares could fall to less than $35. You'd have no reason to exercise your call option, and you would keep the $0.56 net credit. But you could be obligated to buy the Shaw shares at $40.

Let me reiterate... I know this kind of trading isn't suitable for most of our readers. I'm telling you about these potential trades merely to show you what's possible for well-capitalized and experienced options traders.

Maybe that's something you're interested in learning more about, as this kind of options trading remains one of the few good ways to earn high amounts of income in these markets. If you're interested in seeing more trades like this... Or if you simply want to learn more about this kind of advanced options trading, I'd urge you to watch a few of the videos Jeff Clark has prepared for his S&A Short Report subscribers.

Jeff has nearly 30 years of experience trading options. He's a master at figuring out these kind of zero-capital trades, where you can get paid upfront to take a long or short position.

Even if this is something you've never considered doing before... if you have an interest, I'd urge you to learn more about this kind of trading. As always, start with small trades. It's likely you'll make a few mistakes along the way. You want to pay as little "tuition" in trading losses as possible.

And yes, be prepared to jump through hoops with your broker to get qualified to do this kind of trading. It might take a few phone calls. It might take filling out a few forms. Just remember: There's a reason they make this hard to do. And there's a reason not many people talk about these kinds of opportunities. General rule of thumb in finance: If it's easy and everyone is doing it, it's generally a bad idea. No, the converse isn't necessarily true, but it's a good indication.

It was an unmitigated disaster... You'll recall that two weeks ago, in the July 20 Friday Digest, I explained my editors pulled a chart I'd wanted to run in my July issue. It was a regression analysis covering a handful of the world's trophy assets. My editors didn't think most of the readers would be able to interpret it. I disagreed.

I was certain that you guys could figure out that MGM (the gambling and resort company) was trading at an usually big discount to its asset value compared with its sky-high return on equity (around 50%).

I was dead wrong.

I received several hundred e-mails with subscribers picking various stocks on that table. Just about every single stock was "guessed" as the outlier. Only about 50% of the audience selected the right stock. So if you picked MGM... give yourself a pat on the back.

Below, you'll find another, similar regression chart. The two variables we're looking at are value and price. But here, we're looking at the global oil and gas industry.

Unlike the trophy properties we studied two weeks ago, these companies do not have constant access to credit. With these cyclical companies dependent on highly volatile commodity prices, financial distress and even bankruptcy are constant worries for equity investors. So rather than measuring the price of these companies merely by their market cap (the value of all of their shares), we use the full value of their entire capital structure. That's enterprise value – the value of all the shares outstanding, plus all the net debt. We've compared the enterprise value to the current asset value of these companies, using the Securities and Exchange Commission's standards for valuing reserves. You'll find the discount or the premium to asset value on the bottom axis.

To measure the quality of these assets, we're using "lifting costs" – how much it costs each company to produce a barrel of oil equivalent (BOE). You can see this price on the left scale.

So to recap, we've got quality (on the left axis), as represented by lifting costs compared with price (on the bottom axis), defined as the firm's enterprise value discount or premium to asset value. Take a look and see if you can figure out which company represents the best opportunity for investors today. (Careful... some of these companies are in serious financial distress. In these cases, buying the bonds is a much better strategy than buying the stocks.)

By the way... I must be a glutton for punishment because this chart is much more difficult to navigate. Send your best guess here: feedback@stansberryresearch.com.

In the mailbag... a subscriber with hands-on experience working with Chicago Bridge and Iron. As always, we look forward to receiving your feedback. Please send all praise or blame to feedback@stansberryresearch.com.

"I have worked on three nuclear projects with CBI. This is not a company for slackers. These folks hustle all day every day. I believe their workers are paid by piece work, which means competition between workers. Great model." – Paid up subscriber, Stephen

"Just wanted to thank you for all of the terrific newsletters. I find some more to my liking more than others but I do learn something from each of them.

"I had to chuckle at UBS losing millions on Facebook stock. To think these 'experienced money managers' would fall prey to the irrational exuberance in this stock is mind-boggling. These are the same type of people who hand out millions in year end bonuses to these people and justify it by saying "we must keep our top talent from leaving our company.

"Your company has taught me to trust no one but myself when it comes to my family's financial well being. I sincerely appreciate that." – Paid-up subscriber Jamie Diamond

Regards,

Porter Stansberry

Baltimore, Maryland

August 3, 2012