"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
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.
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
Stock price 10/3/05
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
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
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.