Options Can Give You Bang For Your Buck When Buying on a Bounce

It's not for everyone. But options investing could be just the ticket for investors who don't mind risk -- and see the opportunity to profit from market volatility

Investing in options isn't for everyone. To drive home the point, Optionetics.com, the Web site started by options maven George Fontanills, carries this blunt warning: "Do not trade with money you cannot afford to lose." Still, investors who get a kick out of risk and who also want to profit from these herky-jerky market times might want to consider giving a couple of simpler options strategies a whirl.

"I believe that investors mostly think of the stock market in terms of buying stocks or putting money into 401(k)s and letting it ride," says Joe Sunderman, manager of research and development at Schaeffer's Investment Research in Cincinnati, Ohio. "Options give them an opportunity to hedge their portfolios or hedge the downside in a stock."

PUT VS. CALL. First, a quick glossary of terms: With a "call" option, you gain the right to buy 100 shares of a stock at a future date for a fixed price. A "put" option, on the other hand, gives you the right to sell 100 shares of an issue for a set price at a specified date. Generally, investors buy call options when they believe a stock is headed for a recovery while put options are used to protect against an expected drop in a share price.

Why options now? Few on Wall Street are sure when the stock market will switch from rout to rally mode. The Federal Reserve's interest rate cut on Wednesday Jan. 3, 2001 provided a big boost, but Wall Street is still uncertain about whether this move alone will prompt a major turnaround. As a result of the ferocity of the recent sell-off, investors who usually view market dips as an opportunity to snatch up stocks on the cheap have become gun-shy.

But no guts, no glory. Options experts say that if you want to make some nice profits down the road, you'll probably want to play their game. In fact, using options to capitalize on an anticipated turnaround in a certain stock can be cheaper and less risky than buying the equity outright, these market players argue.

BUYING THE BOUNCE. Options investing "is a lower cost way to play stocks," declares Fontanills, president of Pinnacle Investments of America in Boston. "Now's a good time to try to play a bounce."

Because you don't actually buy a stock but instead acquire the right to purchase it at a later date, you have to pony up less cash at the outset. What you pay instead is a premium for the right to buy the stock in the future that is less than the cost of buying the shares outright.

Let's say you have a hunch that Sun Microsystems (SUNW ), which has been roughed up like any other tech stock even though the company is the world's leader in servers, is due for a bounce. Despite a run-up on Jan. 3, 2001, the stock had fallen nearly 25% to about $33 since its 2-for-1 stock split on Dec. 6 when it had opened at $44.25. Analysts have been squawking that a slowdown in information technology spending could crimp Sun's results in the near to intermediate term.

If you think the stock is going to make a comeback in the longer term, however, options experts say you could buy a call option on Sun, or the right to buy 100 Sun shares. For options that expire in January 2002, you would have to plunk down a premium of $11.625 a share, or a total of $1,162.50, for a so-called strike price of $30. A $30 strike price would give you the right to buy Sun stock at $30 a share, regardless of what the stock is fetching a year hence.

Someone purchasing Sun stock itself, by comparison, would have to come up with $33 a share for 100 shares, or a total of $3,300. So to break even in January 2002 with the options strategy, Sun shares by then would have to be changing hands at at least $41.625 -- the premium plus the strike price. If the stock were to double to $66, you would make a profit of $24.375 per share. If an investor had actually bought the stock at $33, the individual would have pocketed $33 a share -- clearly a better deal if the stock goes up.

REDUCED RISK. What if the stock instead fell, however? If Sun halved to $16.50, you would have lost only the $11.625 a share spent on the premium. (Of course, in this case, you wouldn't have bothered to exercise the options to buy the stock.) Meanwhile, the investor who had actually bought Sun stock would be out $16.50 a share. The risk of buying Sun shares would thus have been reduced with options.

It's possible to buy options with shorter expirations, even a short as 30 days. But it can be trickier to bet on a price move in the shorter term, Fontanills says. "The longer you go out, you are probably going to be right on Sun," Fontanills adds. "You are going to be highly speculative in the next 30 days."

PROTECTING POSITIONS. Many options investors buy and sell options before they expire in attempts to make money on changes in the prices of premiums. Options experts caution that this kind of trading isn't for the faint of heart.

But in retrospect many market players say that buying puts would have seen a wise way to protect stock positions from the recent market rout. The story of Extreme Networks (EXTR ), the data networking switch maker, illustrates how buying a put on the stock could have insured an investor against its slide.

Imagine that you had bought 100 shares of the company on Dec. 31, 1999 when Extreme closed at $41.75. The stock had rocketed up 209% to $128.875 by Oct. 17, 2000 before falling extremely hard, like many of its tech brethren. On Jan. 3, 2001, it closed at $40.5625--right about where it was at the end of last year.

If you had sensed trouble ahead after last year's October peak, for a $16.25 a share premium you could have bought a put option that would have entitled you to sell 100 shares at $120 each by Dec. 15, 2000, when the shares had closed at $72.25. If you had done this, you would have netted a profit of $62 a share, which would have been the difference between your selling price and what you had originally paid for the shares including the options premium. That's more than double the $30.50 a share gain you would have pocketed if the stock had been sold at the market rate of $72.25 on Dec. 15, 2000.

"The best time for (the put strategy) would have been when the market was higher," says Scott Fullman, chief options strategist at Swiss American Securities. "The problem with the strategy right now is that we are on the high end of the volatility scale. That means that we are going to pay a lot for puts right now."

Investors can also use the same type of hedging strategy for their entire stock portfolio by buying puts for a stock index such as Standard & Poor's 500 index, Fullman says. "Even if you did it in October or November, you would have been in better shape," Fullman adds.

CHEAPER COMMISSIONS. There may be one more reason to consider options investing. As online trading becomes more popular, the commissions on options trades, which are generally higher than on stock trades, are coming down. Sunderman says that a recent Schaeffer's Investment Research survey revealed that options commissions dipped to 2.07% in 2000 from 2.15% in 1999.

"With the advent of online trading, options commissions have dropped, making it more affordable for the regular Joe investor to dabble in the area," Sunderman says.

Nevertheless, options investing hasn't become any less risky. So Sunderman has one more piece of advice for Joe and Jane investors: Take time to understand what you're doing before dabbling in puts and calls.

By Eric Wahlgren in New York

Edited by Bob Arnold

    Before it's here, it's on the Bloomberg Terminal.