Be Bullish Without Losing Your Shirt

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 (NYSE: AMP  )

(33.2%)

(51.9%)

Liz Claiborne (NYSE: LIZ  )

(42.5%)

(59.4%)

Whole Foods Market (Nasdaq: WFMI  )

(48.3%)

(57.6%)

Ciena (Nasdaq: CIEN  )

(40.2%)

(69.4%)

Ingersoll-Rand (NYSE: IR  )

(25.2%)

(56.2%)

Expedia (Nasdaq: EXPE  )

(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 (NYSE: KO  ) for $45 between now and mid-December. With shares a bit below $44, you would have paid a premium of $2.17 per share, or a total of $217 for that option, yesterday.

Win more, lose less
Now let's fast-forward to mid-December, right before your option expires. Consider two possibilities:

  1. The market rebounds, and Coke goes to $55.
  2. 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:

Are you looking for great bargains without a lot of risk? At Motley Fool Inside Value, our value investing newsletter, we seek out stocks with a margin of safety to help prevent nasty surprises. See what we're recommending for investors right now with a free 30-day trial.

Fool contributor Dan Caplinger has used call options from time to time. He doesn't own shares of the stocks mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Whole Foods Market is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy has no limits.


Read/Post Comments (0) | Recommend This Article (9)

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.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 775468, ~/Articles/ArticleHandler.aspx, 12/20/2014 12:54:59 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement