Getting Long and Strong, Without the Risk

Summer hasn't brought much solace to investors. Sure the Nasdaq's back in the 4000 range, but nobody's feeling too warm and giggly about the short-term prospects of the equity market.

Fine, but there are names you like, names you wouldn't mind owning. Options, long associated with spectacular crash-and-burn collapses of all kinds of investors, actually provide a way to get long without betting the farm.

First, there's the obvious: buying a call option.

An investor, let's call her Jane, really likes the prospects for Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks), but isn't quite ready to plunk down a decent amount of change to buy shares in the portal giant.

So instead, she decides to buy a Yahoo! call option, and thus pays for the right, but not the obligation, to buy 100 shares of Yahoo! at a specific price (known as the strike price) by a certain date (known as expiration). Jane likes the stock's prospects over the near term, at least, and thinks it will have a nice run. However, she doesn't want to run the risk of owning the stock in case things don't go the way she wants.

So with Yahoo! trading around 150, Jane is betting on a big summer rally in Internet stocks and she's confident that Yahoo! is going to have a great run, and by the latter part of July, she thinks the stock's going to be at 175 or above.

So she buys a July 150 Yahoo! call option and the order is filled at 12. She pays $1,200 (12 x 100) for the option. So, for $1,200 (the premium, or price paid for the option contract), she has gained the right to buy 100 shares of Yahoo! at 150. The option expires on July 21, the third Friday of the month.

Had she wanted to get the same exposure in the underlying stock, she would have had to plunk down $15,000 to get 100 Yahoo! shares.

Jane bought what is called an "at-the-money" option, meaning the stock price is at the strike price. She paid a premium of 12 for the contract, so to break even on the trade, shares of Yahoo! have to rise to 162 by the time of expiration. If they do rise above 162, Jane's made a profit if she wants to exercise. Ahead of expiration, if Yahoo! rose to 160, the price of the option would have appreciated enough for her to sell the call back for a profit also.

That's the beauty of buying a call option that goes your way. Conversely, Yahoo! could run into trouble and be trading at, say, 140 at expiration, thus Jane's call option would expire worthless. The most she can lose by buying the call option is the $1,200 she shelled out to buy it.

Had she laid out the 15 grand to buy the shares and they fell to 140, she'd be down $1,000. If they kept falling to, say, 130, she'd be down $2,000. With the call, her downside is limited to $1,200, no matter where the stock is.

In-the-money calls are more expensive than out-of-the-money calls, as in-the-money calls have intrinsic value because the stock price is above the strike price.

If perhaps you're a bit of a gambler and want to be more speculative and want greater leverage, you can buy more out-of-the-money calls because they're less expensive than in-the-money calls. Buying an out-of-the-money call offers greater profit potential because the contract is less expensive, but holds greater risk that the underlying stock price won't rise enough to make the trade profitable.

Put Selling

The other way to get long through the options market is to sell a put option contract.

Selling an option contract -- either a put or call -- is much different than buying one, as the last Options Forum pointed out.

Put options are usually referred to when there's some bearish sentiment around a company. Put buyers are trying to profit from a decline in its shares. Put options can, however, be used to express bullish feelings and get paid in the process.

While a put buyer pays for the right to sell shares at a certain price at a certain time, the seller of the put option is obligated, if the put is exercised, to buy the stock from the put buyer at a predetermined price (the strike price). Stripped down to its most essential fact, selling a put means you're willing to buy the stock; that's a long position.

For selling the option, the seller (also called the option writer) collects the premium for selling the contract. If the put option expires worthless, meaning the underlying stock on expiration day is above the strike price, the option writer keeps the premium and that is the profit.

Investors sell put options to either collect premium or as a way to accumulate stock. The most important rule is to sell puts only on stocks you love. And we don't mean love as in high school sweetheart love; we mean love like your little brother, meaning you're willing to stick around when he's not being so wonderful.

We say this because sometimes put selling can go terribly wrong.

For example, say Jim sells one July 75 out-of-the-money put option on Oracle (ORCL Quote - Cramer on ORCL - Stock Picks), while Oracle is trading around 85. Jim's betting that the put option will expire worthless and Oracle will be trading above 75. Jim sold the contract for 2, taking in $200 in premium for selling the contract. The trade goes Jim's way, and on the day of expiration, Oracle is trading at 80 and the put expires worthless, and Jim gets to keep the premium he received for selling the put option. That's when it goes right.

Jim's friend Bob, however, is a big bull on Oracle. Bob's so confident that Oracle's going to rally, he sells an in-the-money July 90 put option when Oracle is trading at about 82. Bob takes in about a $10 premium, or $1,000.

But by the time expiration rolls around, say Oracle has fallen to 70 and the put option Jim sold is in-the-money and the put option is assigned. Jim has to buy the stock from the put buyer at 90 even though the stock is trading at 70. So Jim, at that point, feels like he's in the shower and someone is flushing the toilet, leaving him scalded. His choices are to either sell the stock right away after it is put to him or hold on to it, hoping Oracle will rebound.

Either way, for the time being, Jim is in pain, and the only consolation he'll find is in a runaway rally on the company.

Whether buying a call or selling a put, both methods are ways to get long via options without putting too much capital at risk. That simple fact, in these confusing days, sometimes can seem like more than enough to keep investors happy.