Avoid This Mistake

"How do you shoot the devil in the back? What if you miss?"
-- Verbal Kint, The Usual Suspects

Options can be a risky way to invest in small caps. There are both explicit and hidden costs that can backfire on the novice investor who tries to "shoot the devil" and misses.

Before I move on to one viable small-cap options strategy, here's a brief recap of the four basic ways you can use options: You can take a long (buy) or short (sell) position in calls or a long or short position in puts.

Really big disclaimer
If you're intrigued by options, know the value of the underlying stock intimately before proceeding. Remember that options should supplement a sound stock investment strategy, not replace it. A big risk with options is not knowing enough about the companies underlying the puts and calls.

It's not enough to simply expect Starbucks (NASDAQ:SBUX) or Target (NYSE:TGT) to lead out of a recession and buy calls in the hopes that, if the company does indeed do well, the price of the stock, and hence your option, will increase. And you can't simply look at high valuation rockets like Green Mountain Coffee Roasters (NASDAQ:GMCR) or Atheros Communications (NASDAQ:ATHR), deem them doomed to fall, and profit from snapping up put options. Expectations, without analysis, won't cut it.

You need to estimate the value of your company. How you accomplish this is up to you -- discounted cash flow, dividend discount, thumbnail valuation, or Ouija board (well, you should probably stay away from the Ouija board ... ). But the key to investing successfully in options is having some assurance that the stock you have your eye on is selling at a good price.

Selling puts
This is a strategy of ownership or, failing that, of income. Assume, after all of your analysis and research, that there's something to this PepsiCo (NYSE:PEP), that the company is reasonably priced today, and that you want to own 100 shares.

A decision needs to be made: Should we buy shares and go on our Foolish way, or should we seek a better price? Remember, we said that PepsiCo was "reasonably priced," not screamingly cheap. (If it were screamingly cheap, you'd be better served just buying shares.) To potentially get that better price, you can sell or "write" a put option. The following data is for a November 2009 expiration put:

If you write the put, you immediately receive $2.10 per share ($210 in total since options come in100-share contracts) from the buyer of the put. In return for taking the buyer's money, at any time up until expiration, your counterparty can exercise the put and force you to buy 100 shares of PepsiCo for $57.50 each. But, because you received $2.10 per share up front, your effective out-of-pocket cost is just $55.30.

Although option buyers can exercise any time up through expiry, "early" exercise is somewhat rare unless the underlying stock takes a real pounding. But it can happen, which is why we advise having cash readily available to buy the shares your put writing has obligated you to buy if necessary.

What could go wrong?
Quite simply, you can be left without shares you'd really like to own. And while there's always the premium received from the buyer of the option, that's cold comfort if the stock starts going up and never looks back.

A good personal example is Logitech (NASDAQ:LOGI), a company I like, but for which I am unwilling to pay much more than $10. I like the cash flow the company generates, but believe an inordinate amount is frittered away on share repurchases meant to offset the company's generous options compensation. This past March, the stock, which had topped $30 less than a year earlier, actually fell below my $10 fair value.

So what did I do? I got greedy. Rather than buying shares (which today would have me sitting pretty with a near-70% short-term return), I wrote $10 puts because some scared soul was willing to pay me $3 to "insure" his shares through next January. True, there are still five months to run between now and expiration, but it's certainly looking like those puts will expire worthless. I'll keep the $3, but arguably, I'd have been better served buying the shares.

Another (self-inflicted) problem that can crop up with put writing is the temptation (usually arising after a few, successful trades) to sell puts representing far more shares than you can reasonably buy (or want). In other words, you hear the siren song of "free money" income, and forget about the associated obligation. For example, in the PepsiCo example above you might consider the $210 received for a single contract to be "small potatoes." You might hear a little voice whispering in your ear about a new bull market, or that PepsiCo is sure to continue rising. What's the harm in selling, not one contract, but 10, and pocketing a cool $2,100?

And maybe you'll get lucky, and the options will expire worthless, letting you keep the money. Or maybe, PepsiCo falls to $50 by expiry, and you're on the hook to either buy 10 times your original allocation, or you have to make good on a $7,500 obligation (the difference between the option-required purchase price, and the then-trading price of the stock).

The Foolish bottom line
If you do your valuation and analysis homework, selling puts only on stocks you want to own at the strike price, and only in a volume you want, and can afford, then the "worst" that can happen isn't so bad. Either you're left to console yourself with cash instead of shares, or you buy shares at a cheaper-than-fair (as per your original assessment) price. Selling puts can be a good route to take a position in superior stocks. For more on Foolish options strategies, take a gander at Jeff Fischer's educational series on options.