Options Amid Uncertainty

 | May 23, 2012 | 1:30 PM EDT  | Comments
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Stock quotes in this article:

atpg

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hitk

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bac

In previous market declines and advances, small-cap stocks have often staged steep declines followed by furious rallies, as they are susceptible to the greatest degree of volatility in both bear and bull markets. A market selloff in May creates small-cap opportunities that appear attractive and likely to generate significant gains if the market climbs higher in the second half.

The same situation happened to small-caps in March 2009 and January 2012. Today, there are hints that the U.S. market could turn for the better later this year: housing is mending, job growth is improving, and the Federal Reserve will likely act if Europe continues to threaten the U.S. recovery. The longer the stock market declines, the greater the upswing will be.

Amid uncertainty, I like the basic options play of investing in multibagger small-caps and ensuring the downside with the purchase of a simple put.

ATP Oil & Gas (ATPG) offers such an opportunity. After climbing to nearly $20 between March 2009 and April 2010, shares are sitting at $5 today. ATP today is a highly levered company, with more than $2 billion in debt against $240 million in cash. Yet the company is rich in reserves and assets that can be monetized -- a tool ATP has used successfully in the past. I don't like the debt, especially in this environment. You can pick up the September 2012 $4 puts for $0.80. The option price-stock price ratio is high in this case, but the potential upside is huge. This is a bet that is willing to take on a 10% - 20% decline in exchange for gains that could easily exceed 100%. Of course, if shares continue to decline quickly, owning the put could eliminate most, if not all, of the loss taken on the equity side.

Hi Tech Pharmacal (HITK) is a small-cap developer and seller of generic prescription drugs. The company has a market cap of $384 million and more than $70 million in net cash. The company boasts net margins in excess of 20% and trades for less than 8x earnings. The stock trades near $30, off from $44 several months ago. You can buy the October 2012 $25 for around $1.10 today. Generic drugs are a big deal, and Hi Tech is a profitable business with an exciting pipeline.

Although it's not a small-cap, the selloff in Bank of America (BAC) shares makes the stock an attractive holding for patient investors. Those nervous about the state of financials could own an appropriate BAC put option.

Volatility in the markets will open the door for a lot of intriguing small-cap bets. Not knowing how much lower prices can go, owning a simple put option against stocks that could stage a huge rally is an intriguing idea.

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