The Low-Risk Way to Ride the Rally

If you didn't buy stocks at March's lows, you're probably feeling antsy to get back into the market before you miss any more of the recent rally. But if you're scared of buying at a potential top, there's a way you can earn potential profits while limiting your losses if the rally reverses itself soon.

Happy days are here again -- but for how long?
After a horrendous 2008, stocks have definitely turned the corner. The S&P 500 has rallied over 60% from its March lows, and many believe that the economy is returning to normal and that stocks can continue to rise from here.

But of course, you've heard all this before. In early 2008, after the fall of Bear Stearns and the opening stages of the subprime mortgage crisis, bears had knocked stocks for a loop, with the S&P dropping 20% from its record highs of October 2007. Many concluded that the worst was over and started piling back into stocks again, pushing the S&P up nearly 15% by May and recovering a good chunk of its previous losses.

Buying in May turned out to be a huge mistake, though, because the biggest losses of the bear market were yet to come. Consider what happened to these stocks next:

Stock

Return March 17, 2008,
to May 19, 2008

Return May 19, 2008,
to March 9, 2009

ConocoPhillips (NYSE: COP  )

22%

(59%)

First Solar (Nasdaq: FSLR  )

53%

(63%)

Morgan Stanley (NYSE: MS  )

28%

(63%)

Tiffany (NYSE: TIF  )

33%

(64%)

Schlumberger (NYSE: SLB  )

31%

(65%)

NYSE Euronext (NYSE: NYX  )

23%

(77%)

Source: Capital IQ, a division of Standard and Poor's.

So if you're thinking about getting into the market now, you may be feeling understandably nervous about the potential losses if you're wrong. Is there any way to invest so that you'll get the benefits from a rebound without having to take huge risks?

A call for higher profits
If you're looking to limit your downside but keep all the upside for yourself, there's a relatively simple options strategy that may interest you. By using call options, you gain when stock prices move up -- but you also set the maximum amount you can lose.

A call option gives you the right to buy 100 shares of stock at a certain price at any time until the option expires. To buy an option, you pay a fixed amount called a premium up front. For instance, on Dec. 8, you could have bought a May call option that would let you buy shares of Coca-Cola (NYSE: KO  ) for $57.50 between now and mid-May. With shares trading around $57.68 at that time, you would have paid a premium of $2.83 per share, or a total of $283 for that option.

Keep your gains, limit your losses
Now let's fast-forward to mid-May, right before your option expires. Consider two possibilities:

  1. The market keeps rising, and Coca-Cola goes to $65.
  2. The market starts falling back, and Coca-Cola drops back to $45.

If the rally continues, you'll have the right to pay $5,750 for shares worth $6,500, so you'll exercise your option. That gives you an immediate $750 gain, less the $283 you paid for the option for a net profit of $467. That's not quite as good as the $732 gain you would have had if you'd bought 100 shares outright at $57.68 -- but it's still a sizable profit.

On the other hand, if the rally ends and stocks drop substantially, buying 100 Coca-Cola shares outright for $57.68 would've cost you $1,268 in losses. But with the option, you'd just let it expire rather than paying $57.50 per share for a stock that's now worth $45. You'd lose the $283 you paid for the option, but you'd avoid losing nearly $1,000 more from owning the stock.

Where options get risky
For some, the appeal of options is the leverage they offer. For about the same $5,768 you'd pay for 100 shares of Coca-Cola, you could buy 20 options contracts controlling 2,000 shares. That magnifies your potential gains -- but there's also a big chance you'll lose the entire sum if Coca-Cola stock falls between now and when your options expire.

The simple answer is not to use options for leverage. In this example, if you have only $5,768 to invest, just buy a single option contract. You'll put less than 5% of your capital at risk, and it makes it a lot easier to exercise your option and buy shares for the long term -- because you haven't overextended your available cash.

Options aren't for the faint of heart. But used wisely, they can be valuable tools to help you enhance your returns. In fact, Motley Fool CEO Ollen Douglass recently made more than $100,000 with a simple options strategy involving six well-known stocks, and he's looking to our Motley Fool Options service for real-money advice on how to build on his profits. To learn more about Ollen's story and find out more about options, just enter your email address in the box below to get the latest information.

This article was originally published on August 6, 2009. It has been updated.

Fool contributor Dan Caplinger has used options for nearly 20 years. He doesn't own shares of the companies mentioned in this article. First Solar and NYSE Euronext are Motley Fool Rule Breakers picks. Coca-Cola is a Motley Fool Inside Value selection and a Motley Fool Income Investor recommendation.The Fool's disclosure policy gives you plenty of options.


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