Investors have been polarized about Krispy Kreme's
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
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.