Know Your Options, Part 2

"How do you shoot the devil in the back? What if you miss?"
-- Verbal Kint, The Usual Suspects

Options can be a risky way to invest in small caps. There are both explicit and hidden costs that can backfire on the novice investor who tries to "shoot the devil" and misses.

Before I move on to one viable small-cap options strategy, here's a brief recap of the four ways you can use options: You can take a long (buy) or short (sell) position in calls or a long or short position in puts.

Really big disclaimer
If you're intrigued by options, know the value of the underlying stock intimately before proceeding. Remember that options should supplement a sound stock investment strategy, not replace it. A big risk (among many) with options is not knowing enough about the companies they represent.

And this knowledge should not simply be expectations-based. Perhaps you expect Microsoft (NASDAQ:MSFT) or Cisco (NASDAQ:CSCO) to do well in the next couple of quarters and consider buying a call in the hopes that, if the company does indeed do well, the price of the stock, and hence your option, will increase. Unfortunately, expectations without analysis won't get you a cup of coffee at Starbucks -- or anywhere else, for that matter.

You need to estimate the value of your company. How you accomplish this is up to you -- discounted cash flow, dividend discount, thumbnail valuation, or Ouija board (well, you should probably stay away from the Ouija board). But the key to investing successfully in options is having some assurance that the stock you have your eye on is selling at a good price.

Selling puts
This strategy is one of ownership and, failing that, of income. From an ownership position, assume that I've determined that Motley Fool Hidden Gems recommendation FARO Technologies (NASDAQ:FARO) represents a tempting value at today's price and I want to own 100 shares. The following data is for a March 2006 expiry put option:

A decision needs to be made: Buy shares and go on our Foolish way, or seek a better price? One way to get that better price would be to sell a put option and immediately receive $2.20 per share ($220 total since options work in 100-share contracts) back from the buyer. Then, at any time up to expiry, the buyer can exercise the option, forcing us to buy his shares for $20. But, because we received $2.20 up front, our out-of-pocket cost would be $17.80 per share. This transaction is called an in-the-money (ITM) sale because the strike price on the option is higher than the current stock price.

Although the option buyer can exercise any time up until expiry, early exercise is somewhat rare unless the underlying stock takes a real pounding. Thus, it's advisable to treat selling puts as a de facto share purchase by having the total amount to buy the shares (including the selling premium from the put) available at the time of the put sale, either in cash or stock you're looking to sell.

I tend to employ this strategy in two situations. First, I employ it for companies in which I'd like to own shares but whose price hasn't yet fallen to my margin-of-safety level. Through the sale of an ITM put, I receive a lower effective price and meet my margin of safety requirement if the option is exercised. Second, I'll sell out-of-the-money puts for a stock in which I already have a full position if it has been hammered by the market for no good reason. In such circumstances, I'll pocket the quick money and wait to see whether I'll be buying bargain shares of a company in which I have long-term confidence.

What could go wrong?
Quite simply, you can be left without shares you'd really like to own. And while there's always the premium received from the buyer of the option, that is cold comfort if the stock starts going up and never looks back.

A good personal example is Portfolio Recovery (NASDAQ:PRAA), a company in which I own shares. In April of this year, the stock fell near $30 on what I believed were unfounded fears of new bankruptcy legislation affecting profitability. I valued the company at closer to $50 and was looking to add shares to my portfolio. I contemplated selling puts for $35 but ultimately decided that I really wanted to own more shares and didn't want to risk missing out. Good thing, too; I would have received around $4.20 for those puts, but the share-price gain to the date of option expiry was closer to $8.

Another problem is that a company that is long on potential but short on cash flows and assets is a poor choice for puts. The combination of too much potential and too little support beneath the share price could result in you purchasing shares for much more than the current market price. That is the biggest danger of employing puts with volatile small caps.

Take Hidden Gems recommendation FlamelTechnologies (NASDAQ:FLML), for example. When it was selected in June 2004, it was trading for $25.20 and had September 2004 expiry options with a $25 strike price trading around $3. Your effective buy price, if put to, would have been around $22.20. A no-lose situation, right? Unfortunately, Flamel's volatility, cash burn, analyst downgrades, and a management battle ended up sending the stock price below $15 by option expiry. The buyer of that put is very happy, and the seller is not yet back in the black.

The Foolish bottom line
If the worst that can happen is that you're left with money instead of shares or are forced to pay more for shares than the market is offering, those are better consolation prizes than some of the other nasty things that can happen with options. Selling puts can be a good, lower-risk route to take a position in superior small caps such as those recommended by Tom Gardner and Bill Mann in Motley Fool Hidden Gems. To date, the team has posted returns of 27.5%, compared with S&P 500 returns of 9.5% over the same time period. To take a look at every issue ever published, and interact with the vibrant Hidden Gems community, click here for a free 30-day trial. There is no obligation to subscribe.

Jim Gillies owns shares of Hidden Gems recommendation Portfolio Recovery Associates. He welcomes feedback. The Motley Fool has a disclosure policy.