Magnify Your Returns With Less Risk

A larger return with less risk is the holy grail of investing, and this article will discuss how buying call options can help you achieve that goal. You'll learn how and when to use calls, plus I'll share several investing ideas, one of which I believe is poised to surprise investors.

Why buy calls:

• You believe a stock has a strong catalyst for appreciation over the coming months or couple years.
• You want to benefit from a stock's upside, but put less capital at risk than buying the stock outright.
• You want to leverage your bullish expectations on a stock you already own.

Buying ("buy to open") call options is a lot like purchasing stock: You believe that a company you understand well will grow in value over a certain period of time, and you want to generate a profit from it. When you buy a call, you have the right to buy the underlying stock at a set price (the strike price) by a specified date (the expiration date). If the stock price goes up, the value of its calls will too. Just as when you buy a stock, your maximum potential loss is the amount you invest -- in this case, the premium you pay for the calls.

Of course, this brings up a logical question: Why not just buy the underlying stock outright? The main reason is to take advantage of controlled leverage. This leverage can magnify your results dramatically and, if you buy calls Foolishly, put less of your capital at risk.

A call in action
Ideal candidates for buying calls are usually companies with (1) stocks that are significantly mispriced and (2) a catalyst (strong earnings, big news such as a merger or new product launch, and so forth) that can help unlock greater value prior to expiration.

In a table below I'll share several call options with shares trading far below their 52-week high, suggesting to investors who know these companies well, that there is room for price appreciation if the market has overreacted. But first, to better understand how buying calls works, let's talk about maximum profit, maximum loss, and breaking even.

Your maximum profit when buying calls
In theory, there's no limit to how high a stock price can go -- and in turn, call options can have unlimited profit potential. But, while that would be a spectacular outcome, let's stay grounded.

Suppose your thesis proves true, and the stock moves up modestly, your call will appreciate by an even great percentage. If you had purchased the stock, you'd earn respectable but smaller gain. Isn't controlled leverage fun?

The other side: your maximum loss when buying calls
Of course, there's a flip side: Leverage makes losses occur more quickly. Fortunately, when purchasing an option, your maximum loss is limited to the premium you've paid -- that's why we refer to it as controlled leverage. Of course, while the stock would need to drop to $0 for the stock investor to lose the entire investment, the same isn't true for us as the options investor -- if shares trade below the strike price on expiration you lose your entire investment.

These losses don't happen all at once at expiration; they occur over the life of a call contract as the time value decays day by day.

It usually makes sense to exit a losing position before the expiration date in order preserve some capital, but sometimes an option loses so much value that selling it makes little sense. To be safe, you need to be prepared to accept a full loss.

Breaking even
An options strategy's break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. When you buy a call, the break-even point is the strike price plus the premium you paid. A good frame of reference here is to only buy a call option if you think the stock will at least achieve this break even performance -- hopefully, you'll do much better.

Which call should I buy?
Here are a few guidelines that will help you when you're buying calls:

• The option should be on a business that you know well,  with good reason to believe is worth much more than its current stock price, and has a catalyst that should help the stock reach your fair value estimate prior to the option's expiration date.
• When choosing an expiration date, allow enough time for your catalyst to pan out. Sometimes they take longer than expected, so it can be wise to use options that expire as far out as possible.
• Don't overleverage, or you'll be risking a very large loss. Only purchase enough contracts to cover the same number of shares you'd be purchasing as a stock position.
• When it comes to strike prices, you have two choices: (1) buy a deep in-the-money call that costs more, but that lets you more easily convert the calls to stock if you need more time for your catalyst to play out, or (2) buy an out-of-the money call that costs less, but increases your odds of losing your whole investment.

The bottom line on buying calls
If you'd like to find out more about how you can use options to boost your returns, simply enter your email address in the box below to receive Motley Fool Options' "Options Edge" 2011 guidebook.