The Low-Risk Way to Ride the Rally

If you didn't buy stocks at dirt cheap prices during the financial crisis nearly two years ago, you're probably feeling antsy to get back into the market before you miss any more big gains. 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 the bear market of 2008 and early 2009, stocks turned the corner and never looked back. The S&P 500 is nearly 90% above its March 2009 lows, and with the recession officially over, 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, which proved to be the biggest losers in the S&P 500 over the ensuing 10 months:


Return March 17, 2008,
to May 19, 2008

Return May 19, 2008,
to March 9, 2009

Genworth Financial (NYSE: GNW  )






Textron (NYSE: TXT  )



AK Steel (NYSE: AKS  )



Lincoln National (NYSE: LNC  )



ProLogis (NYSE: PLD  )



XL Group (NYSE: XL  )



U.S. Steel (NYSE: X  )



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

Understanding these huge turnarounds is fairly simple. For financial stocks, the credit crisis lopped off billions from the value of toxic assets, impairing balance sheets and threatening their financial stability.

At the same time, the markets on which financial companies rely nearly stopped functioning, leaving them in a no-win situation. That also hurt steelmakers and other industrial companies, which need customers to have access to credit to purchase their goods.

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 continuing rally 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. 28, you could have bought an April call option that would let you buy shares of Citigroup for $5 between now and mid-April. With shares closing at $4.78 on that day, you would have paid a premium of $0.25 per share, or a total of $25 for that option.

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

  1. The market rises, and Citigroup goes to $6.
  2. The market starts falling back, and Citigroup drops to $3.

If the rally continues, you'll have the right to pay $500 for shares worth $600, so you'll exercise your option. That gives you an immediate $100 gain, less the $25 you paid for the option, for a net profit of $75. That's not quite as good as the $122 gain you would have had if you'd bought 100 shares outright at $4.78 -- but it's still a sizable profit.

On the other hand, if the rally ends and stocks drop substantially, buying 100 Citigroup shares outright for $4.78 would've brought you $178 in losses. But with the option, you'd just let it expire rather than paying $5 per share for a stock that's now worth $3. You'd lose the $25 you paid for the option, but you'd avoid losing a whole lot more from owning the stock.

Where options get risky
For some, the appeal of options is the leverage they offer. For about the same $478 you'd pay for 100 shares of Citigroup, you could buy nearly 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 Citigroup 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 $478 to invest, just buy a single option contract. You'll put just over 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. Our Motley Fool Pro service has used options to deliver strong returns since its launch. It's been closed to new subscribers since June, but in January, the service will briefly reopen its doors. As a limited-time offer, though, you'll need to act fast. To learn more about Motley Fool Pro and how options and other investing strategies can help you make money, just enter your email address in the box below to get the latest information.

This article was originally published Dec. 10, 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. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you plenty of options.

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