Cut Your Risk With Call Options

Editor's note: This is the introductory options column by Steven Smith. He will write regularly on options for RealMoney.com and provide market coverage for TheStreet.com. As always, let us know what you think.

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If you're looking for a conservative investment vehicle for uncertain times, consider options.

The jury's still out as to whether the economy and the stock market are poised for a turn. Because no one really knows what's next, selectively buying call options can be a better method of wading back into the market than simply plowing money into mutual funds or bottom-fishing in individual stocks.

For those who have never used options, they're often seen as scary tools for the trading-junky crowd. But contrary to those misconceptions, options can be used by mainstream investors in a very conservative, cost-effective way that fits in with long-term objectives.

Investors have been conditioned to not try to time the market, to stay in for the long haul instead. No doubt they've been influenced by relative-return-happy money managers who believe that missing a move up is as real a risk as actually losing money. The S&P 500, after establishing a double-bottom at the 780 level on Oct. 2, has gained some 20%, to 920, leading many to hope that a new bull market is underway.

In Tuesday's Wall Street Journal, Fidelity's legendary money manager Peter Lynch said that "if you had been out of the market for the 40 best performing months over the past four decades, an 11% annual gain would shrivel to less than 3%." But it's hard to be a buyer with both hands right now, considering the three-year bear market in which many big-caps have shed 80% to 90% of their value, the lingering accounting issues and a looming invasion of Iraq.

Time and Leverage

That's where options can come in. Calls limit your risk, require a smaller capital commitment and can achieve equal if not greater returns.

The two most seductive and possibly ruinous components of options are time and leverage. The time element, with the lure of selling something that has no intrinsic value, is a siren song to short-sellers and lazy traders. Leverage, with one option contract controlling 100 shares, can turn a disciplined investor into a crazed lottery ticket shredder. But when properly applied, time and leverage can be very powerful allies.