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.
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
, 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.
Wall Street Journal
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.
Let's keep it straightforward. In the past four weeks the
has jumped 32.6% from its Oct. 8 low, and you're scared you're missing the first leg up of the next bull market. You don't want to be on the sidelines, a poster boy for Peter Lynch's next seminar. Buying call options offers a frugal way to get invested in the market.
Compare the cost, risk and profit potential of investing in a Nasdaq 100 fund, such as the very popular
Nasdaq 100 Trust
, with buying calls on that exchange-traded fund.
The purchase of 100 shares of the QQQ on Wednesday at $26.75 would require an outlay of $1,337.50 (assuming 50% margin) with the full $2,675 contract value technically at risk. Meanwhile, you can buy one Dec. 27 call for $1, meaning your maximum loss is capped at the $100 cost.
If the index gains another 10%, sending the QQQ to $29.43 by Dec. 21 -- remember options expire on the third Friday of the contract month -- the call will be worth $2.43, a 143% increase, for a $143 profit per contract. Compare that with owning 100 shares of the QQQ, in which a 10% move would yield a profit of only $268 despite requiring more than 10 times the capital outlay.
Let's look at a stock-specific example.
, mired in controversy and facing earnings pressure as many of its units have declining revenue, saw its stock jump 39%, from $26.89 to $37.50 over the past four weeks.
If the company can put the conflict of interest issues behind it and the overall market turns up, Citigroup might look cheap and run another 20% in the near term. But the risk is nearly as unquantifiable. Would it shock anyone if another shoe dropped and the stock joined
down in the low $20s?
The Citigroup January at-the-money $37.50 call can be bought for $2.50, or $250 per contract with each contract representing 100 shares. If the shares increase another 20% to $45 by year-end (but remember, calls don't expire until the third Friday of the contract month; in this case, that's Jan. 18, 2003), the calls, according to my unscientific calculation, will be worth $8. Despite being in the money, they will still be awarded some time premium due to the three weeks remaining until expiration.
That's a 220% gain, or a profit of $550 per contract. Owning 100 shares would have yielded a $750 gain, but bear in mind the risk was $3,750, significantly greater than the $250 cost of the call. Even using margin, you would have had to put up $1,875 for the stock.
Dealing With Uncertainty
The point is that call-buying in the near term is a great way to maintain or start building an investment in stocks. If in the next few months accounting issues subside, earnings stabilize, the Iraqi picture clarifies and the October lows hold, you can feel more confident buying stocks and funds outright.
One issue that should be addressed is your brokerage account and how you place orders. Namely, are the commissions cost-competitive and does the system allow you to execute the desired transactions? Most online brokers permit anyone to purchase option contracts, provided they possess a minimal amount of monetary and mental capacity.
But complications can arise in selling or shorting options. Many online brokers won't execute a short option sale, even if it's offsetting a long or creating a covered position against a long stock. Provisions need to be made with your representative and orders may need to be submitted verbally.
Some firms such as
offer spreading, combo and multistrike option orders as part of an online trading package. Systems catering to professionals, such as
, also accommodate options traders.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to