The No-Risk Way to Win With Stocks

After seeing your portfolio get burned in 2008, you might well be ready to swear off stocks for good. But before you give up on stock investing entirely, consider a strategy that will give you at least a portion of the benefits when stocks advance, while protecting you from further declines if 2009 proves not to be the recovery year everyone's hoping for.

Although many people didn't fully realize it until this past year, stock investing involves substantial risk. But there are many tools available to sophisticated investors to manage or eliminate that risk. One strategy that uses a combination of safe investments and a special type of call option can help you capitalize on a rising stock market -- and leave you with plenty of protection if stocks continue to fall.

LEAP beyond the market
Many investors tend to think of options strategies as being high-risk, short-term plays. It's true that a large portion of the volume in the options market comes from trading options that will expire within the next month or two.

But that doesn't mean that you can't execute longer-term strategies using options. One special type of option, known as Long-Term Equity AnticiPation Securities or LEAPS, let you make a multiyear bet on whether a stock will rise or fall over the long run. LEAPS offer you expirations as far as three years into the future.

Still, options aren't for the meek. With stocks, it takes a cataclysmic meltdown to take away your entire investment. With options, though, all it takes to lose your entire investment is for the market to move against you as the expiration date approaches. So how do you make an options strategy risk-free?

Invest what you can lose
The way to turn a risky strategy into a risk-free one is by mixing options with a risk-free investment like bonds or CDs. Specifically, with $10,000 to invest, you could take $9,275 and put it in a 2-year CD at 3.85%. After two years, that CD would leave you a bit over $10,000 -- a guaranteed return of your original principal.

Then, with the remaining $725, you could make a risky bet on an options strategy using LEAPS. Even if you lose the entire $725, you'd still break even -- thanks to your CD. But if you pick the right stock, you could end up with a decent gain.

The tradeoff
Unfortunately, you can't get something for nothing, and the LEAPS strategy is no exception. Although you can get yourself a portion of the upside you'd get from owning the stock outright, you won't get the entire thing.

For instance, based on current option prices, here's a look at how much you could participate in the upside on some commonly traded stocks:

Stock

Recent Stock Price

Recent Price of At-The-Money January 2011 Call

Participation in Upside Compared to Owning Shares

IBM (NYSE: IBM  )

81.33

18.30

32%

Pfizer (NYSE: PFE  )

17.10

2.74

45%

Research In Motion (Nasdaq: RIMM  )

40.85

15.90

19%

Procter & Gamble (NYSE: PG  )

60.53

10.90

40%

Chevron (NYSE: CVX  )

70.35

14.40

35%

Alcoa (NYSE: AA  )

9.78

3.80

19%

JPMorgan Chase (NYSE: JPM  )

29.80

8.85

24%

Source: Yahoo! Finance, CBOE.

The problem with the strategy right now is that options are relatively expensive. You can't afford options on as many shares as you could buy outright with your $10,000 investment. So while you get 100% protection if shares fall, in this example, you get as little as 19% of a stock's gain if shares rise.

In addition, there's another downside of using LEAPS. When you own shares, you receive any dividends paid on the stock. LEAPS owners, however, don't get those dividends. So, for high-yielding stocks like Pfizer, lost dividends are another price you have to pay.

However, keep in mind that this is just a simple example of this options strategy. A more complex combination of options could give you more participation, in exchange for giving up the potential for truly huge moves up.

Anytime you invest, you take on risk. But by looking beyond the stock market to include options, you can control what risks you assume, and get the results that best match what you're looking for from your investments.

To learn more about intriguing stock strategies, read about:

On Jan. 12, 2009, Fool co-founder David Gardner, Jeff Fischer, and their Motley Fool Pro team will accept new subscribers to their real-money portfolio service. Motley Fool Pro is investing $1 million of the Fool’s own money in long and short positions in a range of securities, including common stocks, put and call options, and exchange-traded funds (ETFs). They also incorporate proprietary CAPS "community intelligence" data into their research. To learn more about Motley Fool Pro, and to receive a private invitation to join, simply enter your email address in the box below.

Fool contributor Dan Caplinger prefers 100% participation by buying stocks outright. He doesn't own shares of the companies mentioned in this article. Pfizer and JPMorgan Chase are Motley Fool Income Investor recommendations. Pfizer is a Motley Fool Inside Value selection. The Fool owns shares of Pfizer. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you great options.


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