Many investors jump at every chance they can get to buy stocks at bargain prices. But as bottom-fishers have discovered time and time again over the past year, there's no rule that says that just because a stock has already dropped substantially, it can't keep falling even more.
Bargain-hunters have bloodied themselves trying to catch falling knives in this market. Many investors got used to being able to buy dips during the bull market to get slightly better prices.
But if you didn't adapt to this bear market in time, you got yourself burned. Consider, for example, those who bought stocks back in July, when it seemed that the Fannie Mae and Freddie Mac disaster might create a bottom:
|
Stock |
YTD Return as of 7/15/08 |
Return Since 7/15/08 |
|---|---|---|
|
Ameriprise Financial |
(33.2%) |
(51.9%) |
|
Liz Claiborne |
(42.5%) |
(59.4%) |
|
Whole Foods Market |
(48.3%) |
(57.6%) |
|
Ciena |
(40.2%) |
(69.4%) |
|
Ingersoll-Rand |
(25.2%) |
(56.2%) |
|
Expedia |
(41.8%) |
(58.6%) |
Source: Capital IQ, a division of Standard and Poor's.
It's clear that for most stocks, July didn't come close to a bottom. The S&P has lost nearly 30% more since then.
By now, you might be convinced that a rebound is coming. But 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 rebound without having to take huge levels of risk?
Make the call
If you're looking to limit your downside but keep all the upside for yourself, there's a relatively simple option 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.
When you buy a call option, you get the right to buy 100 shares of stock at a certain price at any time until the option expires. In exchange for that right, you pay a fixed amount called a premium up front. For instance, you could get a December call option to buy shares of Coca-Cola
Win more, lose less
Now let's fast-forward to mid-December, right before your option expires. Consider two possibilities:
- The market rebounds, and Coke goes to $55.
- The market keeps falling, and Coke drops to $35.
If the market rebounds, you'll have the right to pay $4,500 for shares worth $5,500, so you'll exercise. You can either hold on to those shares or sell them right away for an immediate $1,000 gain, less the $217 you paid for the option for a net profit of $783 or $7.83 per share. That's not quite as good as the $1,100 gain you would have had if you'd bought 100 shares outright at $44 -- but it's still a sizable profit.
On the other hand, if the market drops further, buying 100 Coke shares outright for $44 would've cost you $900 in losses. But with the option, you'd just let it expire rather than paying $45 for shares that are now worth $35. You'd lose the $217 you paid for the option, but you'd never lose any more than that.
The danger of leverage
For some, the appeal of options is the leverage they offer. For the same $4,400 you'd pay for 100 shares of Coke, you could buy 20 options contracts controlling 2,000 shares. That magnifies your potential gains -- but there's also a big chance you'll lose the entire $4,400 if Coke's stock continues to fall between now and when your options expire.
The simple answer is not to use options for leverage. In this example, if you have only $4,400 to invest, just buy a single option contract. You'll put only 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 can definitely be risky. But if you use them wisely, they can also be valuable tools. Call options are just one way to limit your losses while still keeping the possibility of huge gains.
For more on controlling your risk, read about:
- Stocks you could bet your house on.
- The best value stocks, dirt cheap.
- The way you can keep from poisoning your portfolio.
