For five straight years, the Dow Jones Industrials (DJINDICES:^DJI) have posted substantial gains, recovering from the extensive damage that the 2008 recession and market meltdown did to the economy and the stock market. Yet, now that many investors have finally gotten comfortable with the idea of investing in stocks again, contrarian investors worry that an influx of new investors into the stock market could bring the Dow's five-year bull market to an end.
Fortunately, there's a way to take positions in the Dow Jones Industrials without assuming the full risk of owning the stocks themselves. By using a strategy involving options, you can profit if the Dow keeps rising, while limiting your downside risk if January's Dow correction turns into a more extensive pullback.
Using call options
Many investors avoid options because of their reputation as a highly risky investment. It's true that options often involve the risk of complete loss, and when used improperly, options strategies can wreak havoc over unsuspecting investors' portfolios.
But when you want to limit your losses while still participating in further moves upward, either for a stock index like the Dow or for individual stocks, then simple strategies involving buying call options can be a great way to accomplish your task.
For instance, say that with the Dow at around 16,200, you expect the average to keep rising between now and midyear. You could buy a June 160 call option on the Dow Micro index, which is equal to 1% of the value of the Dow. Currently, such an option would cost you about $550.
If the Dow does rise between now and mid-June, then the option will be worth the number of dollars by which the Dow's closing value exceeds 16,000. So if the Dow jumps to 17,000 by June, then your option will be worth $1,000, and you'll book a $450 profit.
At the same time, though, your risk under the option is limited to the $550 you paid for it. Whether the Dow drops to 16,000, 15,000, or 5,000, your loss is the same $550. When you compare that to the thousands of dollars you would lose by buying enough shares of the SPDR Dow Jones Industrials ETF (NYSEMKT:DIA) to match the upside potential of the option position, you can see the risk advantage that options can carry.
Where people get into trouble with options is when they think that they should take advantage of the leverage that options make possible. For instance, if you wanted to make a leveraged bet on the Dow, you could get almost 30 times more upside exposure by buying 30 June 160 calls on the Dow micro than you would buy spending the same amount of money on 100 shares of the SPDR Dow ETF. At the same time, your risk of losing the entire $16,000 to $17,000 you'd spend on each respective position would be much higher with the options strategy.
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.