Investors have been polarized about Krispy Kreme's (NYSE:KKD) future for as long as it's been a public company, particularly here at the Fool. There have been duels about the stock, and recently, Bill Mann made the extreme suggestion that Krispy Kreme's true value might be zero.
Even David Gardner has been active in the discussion. While many of his Motley Fool Stock Advisor picks show 100%-plus gains, his pick of Krispy Kreme about a year ago has shown the value of diversification (a euphemism for "plummeted like a bird-hungry coyote.")
Investors want to own companies with huge competitive advantages, but such companies are often cheap only when there are problems, like McDonald's (NYSE:MCD) 18 months ago, or Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL), and Krispy Kreme now. I still believe that Krispy Kreme could become the next Starbucks (NASDAQ:SBUX), but recognize that it could also collapse. I want the upside, but want to avoid a large potential loss.
That's why I own long-term call options on Krispy Kreme. In general, options warrant great suspicion, as they're able to demolish portfolios in less time than a Jennifer Lopez marriage if used improperly, or even properly. But in certain cases, they can make sense for the right investor: one willing to endure a unique, and not unsubstantial, form of risk in return for return potential (potential, mind you) largely unknown to equity investors.
Call options give you the right to buy a stock at a given "strike" price sometime in the future. Suppose I buy a Krispy Kreme January 2007 call option with a strike price of $20 for $1.75. Then, any time until January 2007, I can use my option to buy Krispy Kreme for $20. This seems stupid, because the stock was recently trading at $12.55.
However, suppose the company overcomes the current difficulties and, before the option expires, bounces back to its year-end 2003 price of $36.60. I can exercise the option to buy shares at $20, and immediately sell them for $36.60, making $16.60, a ten-bagger. But if Krispy Kreme stays under $20, I lose 100% of my investment. (For simplicity, transaction costs have been excluded.)
This strategy can work because options are proportionately much cheaper than shares, yet still have significant upside. I can buy options on 300 shares for $525, while buying 300 shares directly would cost $3,765. If Krispy Kreme hits $36.60, I'll make $4,455 using the options or $7,215 with the shares. But if Krispy Kreme becomes worthless, then I only lose $525 rather than $3,765.
Bottom line: Great bang for the buck, but a decent chance of losing 100%. Because of this, I restrict options to a small percentage of my holdings and keep individual positions to well under 1% of my portfolio. Since the downside is going to be a complete loss on some trades, I not only look for positions that have big-gain potential, but try to resist the temptation to take small gains by selling prematurely -- in other words, because I'm playing win big/lose big, middle-of-the-road profits don't help me much.
Is this strategy for you? Odds are, no. But if you are interested, remember that I'm just introducing something here; there are many more facets to consider, so learning more is a must if you do feel options may work for you. The Fool FAQ on Options is a good place to start.
For related Foolish analysis, see:
- Saving Krispy's Kreme
- Krispy Kreme's Fair Value: Zero
- Fool FAQ: Options
- The Dow's Ten-Baggers
- Bullish Options Strategies
Fool contributor Richard Gibbons owns Krispy Kreme shares and call options, but none of the other companies mentioned in this article.
