As a value investor, I generally avoid the use of options for one simple reason: they act like ticking time bombs. All options have a finite lifespan and each and every day that passes by, the time value of that lifespan ticks away at the value of the option.

Go Long Options
However, if used prudently and conservatively, options can be advantageous to the investor. For one, the capital requirement is a fraction of what's needed to assume the underlying position represented by the option. Second, the return on investment can be quite tidy.
Knowing both the disadvantages and advantages, I find it appropriate at times to forgo the outright equity purchase and instead buy the long-term option. By long-term I mean buying the long-term equity anticipation securities (LEAPS) or options one to two years out.

The Same Rules Apply
Whether buying the underlying stock or the LEAP, the same rules apply: participate only those situations in which you understand that offer a comfortable margin of safety. In other words, only buy call options on businesses that are under priced and offer a excellent upside potential. (For a quick refresher, check out Option Basics: What Are Options?)

IN PICTURES: 7 Tools Of The Trade

The Candidates
One excellent candidate would be fertilizer giant Mosaic (NYSE:MOS). Shares in fertilizer stocks have come down significantly from their highs last year. Mosaic, which now fetches $54 traded for $150 back in June of 2008. Fertilizer demand may have slowed down, but it will surely come back: farmers can only delay fertilizer use, not abandon it.

At the time of writing, investors could purchase the Mosaic January 2011 call option with a strike price of $100 for $1.90. If fertilizer demand begins to pick up early next year like many executives are suggesting, Mosaic shares could easily near their 2008 prices by the end of next year. If the shares reach $110 by January 2011, the options are worth $10, a five fold return.

Another "option in lieu of the stock" idea might be Sears Holding (Nasdaq:SHLD), although in this case you're making the bet on Sears chief Eddie Lampert. Lampert's a brilliant CEO who continues to buyback his own stock. The retailing business is a disaster right now, but if Mr. Market gets in the right mood over the next year, shares could enjoy a nice lift. They trade around $65 today; before the Lehman debacle last year, shares fetched $97 - a year before that they fetched over $130.

You won't find a CEO working harder to right the ship than Lampert and a small position via a Jan. 2011 option could pay off big if he succeeds.

This option strategy worked fantastically during March when excellent financial firms like Goldman Sachs (NYSE:GS) and Wells Fargo (NYSE:WFC) were trading for $90 and $9, respectively. These financials were priced for extinction and an investor with a strong conviction that they would survive could have made a smart bet on their survival employing little capital by buying the long-term call options. Today Goldman fetches $160 and Wells trades at $27. In both cases, these options netted return in excess of 900% on certain strikes. Back in March, the Wells Fargo Jan. 2011 $20 call was trading for around $1; today it's worth $10.40.

Bottom Line
Any option position should be treated with the utmost respect. Despite the phenomenal upside potential, the downside is an easy 100% loss on investment. Use them prudently as another way to invest alongside your favorite investment candidates. (For more, see Trading A Stock Versus Stock Options - Part One.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  3. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  4. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  5. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  6. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  7. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  8. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  9. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  10. Investing News

    Corporate Bonds or Stocks: Which is Better Now?

    With market volatility high, you may think it is time to run for corporate bonds instead of stocks. Before you do take a deeper look into which is better.
  1. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!