A Safer Bet on Future Stock-Market Gains

The S&P 500 (SNPINDEX: ^GSPC  ) has been hitting new record highs throughout the past several months as the bull market continues to unparalleled heights. Yet nervous investors are starting to wonder whether the stock market is long overdue for a correction that could make buying shares at current near-record levels look awfully silly.

Obviously, if you think the market will definitely fall, then waiting on the sidelines until the correction actually happens is your best move. Yet by doing so, you'll also miss out on further gains if your prediction turns out to be wrong -- or simply mistimed.

Fortunately, there's another way you can minimize the risk of loss while still enjoying the benefits of further gains in the stock market. By buying call options, either on the index itself of on exchange-traded index funds like the SPDR S&P 500 ETF (NYSEMKT: SPY  ) , you can define your acceptable loss level while still profiting from further gains if the S&P rises to new record heights.

How options can limit your risk
Options have a reputation as being risky, and with good reason, as many questionable strategies use the huge leverage available from options as an attempted shortcut to riches. Occasionally, you can score huge gains from such strategies, but you can also lose every penny you invest if things don't happen exactly the way you hope.

But if you're prudent about how you use options, then you can define your risk level so that in some cases, it's actually less than what you'd see from simply buying ordinary shares of stock outright. Here's an example: as of Friday's close, you could have bought shares of the SPDR S&P ETF for $169.30 per share, or you could have bought a call option giving you the right to pay $165 per share for 100 ETF shares, with that option costing you $5.60 per share. If you bought the shares, you'd profit from market gains and lose money from market declines in complete lockstep with the market. A big jump in shares would make you big profits; a crash could crush your investment.

With the call option, your risk profile would be much different. If the SPDR share price rose from $169.30 to $170.60, then you'd break even on your option purchase, paying a total of $165 for each ETF share plus the $5.60 per share for the option. If the market didn't move, you'd lose $1.30 per share, while under any scenario in which the SPDR finished above $165, you'd end up $1.30 per share behind where you would've been if you'd simply bought the shares outright.

However, in the event of a crash, the most you could ever lose with the option is $5.60. Even if the ETF corrected by 20% -- costing ETF buyers almost $34 per share, the option gives you the right but not the obligation to buy the stock. If such a crash occurred, you'd simply let the option expire -- sacrificing the $5.60 you paid but avoiding much larger losses.

Why options are a good value right now
In particular, now's a good time to consider buying options, because the S&P Volatility Index (VOLATILITYINDICES: ^VIX  ) , which is one measure of how much buyers have to pay for options, is extremely low. Essentially, what low volatility means is that in the example above, the $1.30 per share you sacrifice in most cases in order to limit your maximum loss is less than what you might normally expect under more typical circumstances.

Not everyone is comfortable using options, and they're not essential for long-term investing success. But if you like the idea of lower risk with continued upside, today's relatively cheap option prices make buying options particularly attractive for those looking to be more conservative with their stock portfolios.

Buying call options is one way you can get off the sidelines and get your money working harder for you. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.


Read/Post Comments (3) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2013, at 12:35 PM, EricTheRon13 wrote:

    Good primer. But if you're highlighting options for safety, why wouldn't you mention put options? I mean the tactic of buying SPY and also a future PUT that guarantees a lower base price for selling your shares at a future date. That means your possibility of loss is limited, but maybe the option is too expensive at times (certainly when things have already gotten volatile).

  • Report this Comment On August 10, 2013, at 9:25 PM, TMFGalagan wrote:

    @EricTheRon13 - Buying the stock plus buying a put has an identical risk profile to buying a call. But I'll be looking at put options tomorrow.

    best,

    dan (TMF Galagan)

  • Report this Comment On September 03, 2013, at 7:01 PM, Egd1 wrote:

    I'm a subscriber to Motley Fool 360 and Motley Fool Options. I'm new to MF 360, so I'm cautiously using the recommendations as follows: take a recommended stock, sell a put option for that stock at one strike out-of-the-money with a short expiration, e.g.2-3 months. If assigned, I get the recommended stock at less than if I bought it (at my breakeven price). If not assigned, I keep the premium. Seems to work.

    egd1

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