An Easy Strategy to Ease Into Options

Just when you thought the market was safe again, a day like Monday serves as a stark reminder that despite the huge losses of the past year and a half, stocks can still fall further. In response, many people have scurried for cover, looking for investing strategies that will allow them to reduce their risk.

Few of these investors will look to options strategies for solutions to their risk management concerns. Yet while many investors use options to magnify risk rather than controlling it, a variety of options strategies exist that can actually reduce your exposure to the market -- while still allowing you to reap some of its benefits.

The lose-everything trap
Options strategies get complicated in a hurry, and with good reason: for every stock, there are dozens of different options available, and an even greater number of combinations of options you can put together to achieve a particular goal. By choosing one option over another, you can be bullish or bearish, risk a small amount or a huge one, and control the likelihood of making a profit.

The biggest concern in using options is how easy it is to lose your entire investment. For instance, if you're bullish on a stock but want to limit your downside, buying a call option gives you the best of both worlds: profits if the stock rises, but limited loss if the stock falls. The problem, though, is that you can easily lose your entire investment in an option if things don't go your way.

Spread out your risk
That's where spreads come in. Spreads involve using two options: buying one and selling one. For a bull spread, you buy a call option with a given strike price and sell another call option with a higher strike.

Compared to just buying the call option outright, a bull spread limits your upside, but the overall position is often much cheaper. Consider an example:

Wal-Mart (NYSE: WMT  ) shares closed Monday at $49.27. A simple bullish options strategy would be to buy a call option. A May 50 call would cost you $1.44 per share, letting you share in all the upside if shares rise above $50 by this time next month. But if Wal-Mart stays where it is, then you'll lose the entire $1.44.

In contrast, a bull spread might involve buying the May 50 call but selling the May 52.5 call for $0.60. You no longer have unlimited gain potential -- even if shares soar well above $52.50, the most you'll gross from the strategy is $2.50, leaving you a net profit of $1.66. But you also cut your maximum loss almost in half, from $1.44 to $0.84.

Limiting risk
Bull spreads let you bet on rising shares, while the similar bear-spread strategy involves put options and pays profits when shares fall. Depending on exactly which options you use, you can change your risk profile substantially. Here are a few more examples:

Stock

Share Price

Buy Option

Sell Option

Net Cost

Oracle (Nasdaq: ORCL  )

18.82

December 19 call (2.30)

December 23 call (0.95)

1.35

Merck (NYSE: MRK  )

25.22

July 25 call (2.15)

July 27.5 call (1.05)

1.10

SPDR Financial (NYSE: XLF  )

9.87

June 10 put (1.32)

June 8 put (0.51)

0.81

Sears Holdings (Nasdaq: SHLD  )

59.32

June 60 put (8.70)

June 50 put (3.80)

4.90

Goldman Sachs (NYSE: GS  )

115.01

Oct 100 call (27.40)

Oct 120 call (16.45)

10.95

Microsoft (Nasdaq: MSFT  )

18.61

Oct 24 call (0.55)

Oct 25 call (0.39)

0.16

Source: CBOE. Prices as of market close on April 20.

As you can see, you can tailor your strategy in any number of ways. You can go after a small gain with an even smaller risk of loss, or you can look to reap big rewards but potentially lose a lot more.

Not for the meek
Of course, even spreads involve plenty of risk. If the stock moves against you, you'll still lose the full net amount you paid for the position. But the spread strategy offsets your losses somewhat from what you'd lose just by buying a single option.

Many investors find options too cumbersome and difficult to analyze. But if you want to tailor your portfolio exposure to exact specifications, you can't find a better tool than options. And for beginning options investors, spreads are a great way to get to see how the options market works without taking on the full risk of a more aggressive strategy.

For more on options, read about:

Our invitation-only Motley Fool Pro service has used a variety of options strategies to seek out market-beating returns. Find out more by clicking here.

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Fool contributor Dan Caplinger uses options on a regular basis to manage risk. He doesn't own shares of the companies mentioned in this article. Microsoft, Sears Holdings, and Wal-Mart are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you all the options.


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