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The Safer Strategy to Bet on a Bounce

Dan Caplinger
September 30, 2011

This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.

After seeing a big rally that started last summer, investors have gotten another reminder of how the stock market involves both risk and reward. As Europe continues to have problems with sovereign debt worries and the U.S. treads closer to a potential double-dip recession, the stock market has given up a big chunk of its gains from the rally, and some bearish investors see it on the precipice of a much bigger decline.

Even those who believe investing for the long run is the best strategy to follow can find it hard to add new money to the market in situations like this. After all, as downward moves continue, traders using short-term technical and momentum indicators often end up making the declines worse as they add short positions to the overall selling. But you don't want to miss out on what could turn out to be a big bargain. A strategy involving options could be exactly what you're looking for.

When big losses aren't an option
If you're like many people, the whole idea of using options sounds dangerous. Whereas stocks tend to retain at least some of their value no matter how big a downturn ends up becoming, options often produce total losses. And because some options strategies require you to take high-risk bets in the hopes of highly levered gains, the amounts involved can make options seem more like gambling than investing.

But once you get to know options, you'll understand that like many tools, options are only as risky as you make them. By following the ideas below, you can actually invest in stocks while reducing the risk of future losses.

Make the call
This particular strategy involves call options, which allow their holders to buy shares at a certain price any time before the options expire. With calls, you have complete exposure to share-price gains but limit your potential loss to whatever amount you pay for the call.

One place you might want to look for a recovery in is the materials sector, which is the worst-hit sector of the S&P 500 in September. The drop in precious metals has thrown miners like Goldcorp (NYSE: GG  ) , Silver Wheaton (NYSE: SLW  ) , and platinum/palladium producer Stillwater Mining (NYSE: SWC  ) for a loop. But the declines have gone much further than precious metals, as concerns about a global slowdown have led to big drops in prices for copper and other base metals, pushing down shares of Freeport-McMoRan Copper & Gold (NYSE: FCX  ) and BHP Billiton (NYSE: BHP  ) in sympathy.

Risk-averse investors should consider a strategy known as a bull call spread. By buying one call to purchase shares at a fixed price and then selling another with a higher purchase price, you can firmly set both your maximum potential profit and your biggest possible loss. The following table shows how the strategy could work right now: