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?)
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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.
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.)
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