The Low-Risk Way to Ride the Rally

If you didn't buy stocks at March 2009's lows, you've probably felt antsy to get back into the market for quite a while before you miss out on any more gains. But if you're scared of buying at a potential top, there's a way you can earn potential profits while limiting your losses if the rally reverses itself soon.

Happy days are here again -- but for how long?
After the bear market of 2008 and early 2009, stocks turned the corner and never looked back. Even after six straight weeks of declines, the S&P 500 is still 90% above its March 2009 lows, and although the economic recovery has come in fits and starts, many believe that the economy will continue to grow and that stocks can rise further from here.

But of course, you've heard all this before. In early 2008, after the fall of Bear Stearns and the opening stages of the subprime mortgage crisis, bears had knocked stocks for a loop, with the S&P dropping 20% from its record highs of October 2007. Many concluded that the worst was over and started piling back into stocks again, pushing the S&P up nearly 15% by May and recovering a good chunk of its previous losses.

Buying in May turned out to be a huge mistake, though, because the biggest losses of the bear market were yet to come. Consider what happened to these stocks next:

Source: Capital IQ, a division of Standard and Poor's.

For financial stocks like iStar and CapitalSource, the credit crisis lopped off billions from the value of toxic assets, impairing balance sheets and threatening their financial stability. At the same time, the markets on which financial companies rely nearly stopped functioning, leaving them in a no-win situation. That also hurt smaller tech companies like Level 3 and Cypress, which need their customers to have access to credit to purchase their products. And with energy and commodities stocks like Arch Coal, Cliffs, and SandRidge, the bursting of the commodity bubble that had sent oil prices to nearly $150 a barrel and other natural resources prices through the roof brought these former high-flyers back down to earth in a hurry.

So if you're thinking about getting into the market now, 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 risks?

A call for higher profits
If you're looking to limit your downside but keep all the upside for yourself, there's a relatively simple options 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.

A call option gives you the right to buy 100 shares of stock at a certain price at any time until the option expires. To buy an option, you pay a fixed amount called a premium up front. For instance, on June 13, you could have bought an October call option that would let you buy shares of Cliffs Natural Resources for $85 between now and mid-October. With shares trading right around $85 at that time, you would have paid a premium of $8.55 per share, or a total of $855 for that option.

Keep your gains, limit your losses
Now let's fast-forward to mid-October, right before your option expires. Consider two possibilities:

1. The market rises, and Cliffs goes to $120.
2. The market starts falling back, and Cliffs falls to $60.

If the rally continues, you'll have the right to pay $8,500 for shares worth $12,000, so you'll exercise your option. That gives you an immediate $3,500 gain, less the $855 you paid for the option, for a net profit of $2,645. That's not quite as good as the $3,500 gain you would have had if you'd bought 100 shares outright at $85 -- but it's still a sizable profit.

On the other hand, if the rally ends and stocks drop substantially, buying 100 Cliffs shares outright for $85 would've brought you $2,500 in losses. But with the option, you'd just let it expire rather than paying $85 per share for a stock that's now worth $60. You'd lose the $855 you paid for the option, but you'd avoid almost three times as much from owning the stock.

Where options get risky
For some, the appeal of options is the leverage they offer. For about the same $8,500 you'd pay for 100 shares of Cliffs, you could buy 10 options contracts controlling 1,000 shares. That magnifies your potential gains -- but there's also a big chance you'll lose the entire sum if Cliffs' stock falls between now and when your options expire.

The simple answer is not to use options for leverage. In this example, even if you have $8,500 to invest, just buy a single option contract. You'll put around 10% 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 aren't for the faint of heart. But used wisely, they can be valuable tools to help you enhance your returns. Our Motley Fool Options service has used options to deliver strong returns since its launch, with lead advisors Jeff Fischer and Jim Gillies clocking in with a 96.7% success rate on their trades. The service is reopening to new subscribers, but you need to act fast. Just click here or enter your email address below to learn more about Motley Fool Options and how options strategies can help you make money.