Cisco (CSCO) - Long Term Option Strategy Beats Buying Stock

As a lead in I have always felt that there really is no sense ever buying an equity where the options are liquid with tight spreads, because if you are confident in your view, the use of leverage allows you to better position for larger gains, whether you want to use deep in-the-money calls/puts or play the upside with out-of-the-money options. Also, if you are a long term investor willing to buy a stock at a certain level, why not just sell a cash secured put where you improve your cost basis due to the premium. If your fear is missing a big upside move, you can go long a call along with short a put for a risk reversal, a strategy that can amass huge gains if you catch a trend, or use a synthetic.

Anyway, I wanted to take a look at Cisco (CSCO), the $82.8B much-maligned former Tech leader. For months I have seen "value-gurus" trying to call the bottom and get long this Company, first on the move down to $18 on earnings, and more recently around the $16 level. Cisco is cheap on all metrics, trading 8.85X forward earnings, 1.9X sales and 8.95X cash flow, and also with around $40B in cash, or nearly half the market cap. One would question why management is not actively making acquisitions to drive growth, or returning money to shareholders in the form of a dividend, or even a special one time payment. Either of these actions would result in shares heading higher in my opinion, just anything to change the current sentiment, or maybe even a shakeup in management.

I'd rather not get too deep into the Cisco situation, as my goal is to lay out a strategy that is a much better play than simply trying to catch shares in this sharp trend lower. Shares are nearing the $14 level, which would be a 50% haircut from the early 2010 highs, and also a spot for a potential double bottom with the 2008 lows.

Most of the Street maintains $20+ targets on shares, seeing the longer term value.

The trade that caught my eye today was 10,000 January 2013 $20/$10 bullish risk reversals at a $0.23 Net Debit, buying the $20 calls and partially funding via selling the $10 puts.

The $230,000 outlay is a 41 Delta position, or equivalent to being long 410,000 shares of Cisco stock.

Through this strategy you are leveraged to being long Cisco, and if shares head higher the value of the calls increases, while the value of the puts decrease, and as that spread widens, a relatively small move higher in the stock can quickly double, triple, or more your $0.23 basis on the spread. I would note that the spread requires margin, so you would want to do this at a size where you are willing to be long Cisco (CSCO) at $10, so if you want $25,000 of Cisco, you can put on 25 of these spreads (note cost basis is actually $10.23 due to the debit, adjust accordingly).

The beauty of this strategy is that for a small outlay you limit your risk, but can participate in more of an upside move. If shares were to somehow tank below $10, making Cisco (CSCO) the greatest value buy of all time, you are willing to be long stock at $10.23, and did not just lose 33% on your equity position. If shares of Cisco have a resurgence and reach $25 by 2013, the spread is worth $5, roughly 20X your investment.

I would also note, if you see even less downside potential in Cisco, you could put on the January 2013 $17.50/$12.50 bullish risk reversal for less than $0.10.

These type of spreads are often done at a net credit, my preference, so you have zero outlay, willing to be long at a certain level, but able to participate in an upside move with maximum leverage.

These risk reversals are risky for growth stocks and high Beta stocks, but when you are looking at a beaten up value name with a limited downside view, it can really accelerate your returns.

Good Luck!