The Safer Way to Play a Rebound

Here we go again.

After enjoying the year-long rally, investors are now once again dealing with the painful side of the risk-reward equation. The dire combination of European problems and the Gulf oil spill, added to the background noise of general economic concerns, pushed the stock market to its lowest closing level since last November. Even more worrisome is the fact that as the bearish move gains steam, short-term traders who use technical analysis and momentum-based indicators may well add fuel to the downturn by dumping remaining stocks and adding short positions.

Even if you're a long-term investor, it can still be hard to commit your hard-earned money to the stock market when things look dire. Instead of taking on the full risk of stocks, you might prefer some sort of compromise that would give you at least some profits from a market rebound while protecting you from the full brunt of a possible collapse. Fortunately, there's a way you can dial your risk to your exact comfort level.

Give yourself the option
To many, options are intimidating. While you may feel completely comfortable investing thousands of dollars in a stock, spending a smaller amount to implement an options strategy can still give some the heebie-jeebies.

The reason for this anxiety comes from the high-octane methods that some traders use with options to speculate on stocks and the overall market. Options can give you immense leverage over your portfolio, giving gamblers a prime way to shoot for the moon -- or go bust trying.

But just because some people use options as a way to maximize their leverage doesn't mean you have to. One simple strategy can provide a way for you to invest in stocks while taking on less risk than you would by simply buying the shares.

Call me
The strategy uses call options, which give you the right to buy shares for a fixed price within a certain timeframe. Call options give you theoretically unlimited upside if a stock rises, but you can never lose more than you pay for the option.

Let's take a look at one sector that many are looking to for a rebound: energy. The disaster in the Gulf has not only taken a huge bite out of BP's (NYSE: BP  ) shares, but has also had a big impact throughout the industry. Although investors in ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and ConocoPhillips (NYSE: COP  ) may feel like they've dodged the bullet by not being associated with the BP debacle, those companies may yet face the brunt of new regulation and restrictions on drilling. Those prospects have pushed shares of all of these companies down sharply. Moreover, as major companies, they're all vulnerable to general downdrafts in the stock market.

The options strategy I'd suggest for risk-averse investors right now is called a bull call spread. What you do is buy one call at a certain strike price and sell another call with a higher strike price. If the stock falls, the most you can lose is the net amount you pay for the position, after accounting for the money you receive for the call you write. If the stock rises above the strike price of the call you write, your position will reach its highest value. The extra money above the cost of your position is pure profit.

The following chart, based on yesterday's market prices, may give you a better picture of how the bull call spread strategy can work:

Stock

Buy This Call

Write This Call

Maximum Loss

Maximum Profit

BP

October $37

October $45

$2.83

$5.17

ExxonMobil

October $60

October $70

$3.00

$7.00

Chevron

December $80

December $100

$2.37

$17.63

ConocoPhillips

November $55

November $70

$1.86

$13.14

Energy Select Sector SPDR (NYSE: XLE  )

December $50

December $55

$2.50

$2.50

Source: Yahoo! Finance. Based on June 7 closing prices.

Now keep in mind that as with any options strategy, you have to make trade-offs to avoid the full risk of owning the stock. With a bull call spread, you may lose your investment even if the stock stays at or near current levels. Moreover, your gains are limited by the options you choose, so if the stock rises even higher, you won't get any additional benefit.

Nevertheless, if you're comfortable with making those trade-offs, then the bull call option strategy may be the best way to control your risk. With it, you can profit from a rising market without losing sleep at night.

Learn more about options in our options tutorial by Motley Fool Options co-advisor Jim Gillies.

Fool contributor Dan Caplinger likes to keep his options open. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't jilt you and doesn't mind if you're on the rebound.


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