While investing in stock options can often carry more risk than buying the underlying equity, investing in options can also make sense if used prudently. As a substitute for the buying the stock, buying options can create a levered return that is many multiples of the gain otherwise achieved owning the equity. (For a quick refresher, check out The Benefits And Value Of Stock Options)
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The Price You Pay
The upside leverage provided by options is provided at the expense of a total loss. It's that simple: when you invest in any stock option, accept the fact that a more than small probability exists for a total investment loss. Understanding this simple risk reward equation, investors can consider using options instead of buying the stock. Specifically, the use of long dated options, or LEAPS, is the best way to implement this strategy. Because options have a finite period of time, LEAPs are often to most prudent way to invest in a stock via an option. My number one rule in buying LEAPs: only do so in place of a share of stock that you have to determined to have significant upside due to attractive fundamentals. (For more, see Long-Term Equity Anticipation Securities: When To Take The "LEAP"?)
The Chosen Few
With what looks to be another good year for stocks, many shares prices leave enough value on the upside to warrant the use of LEAPs. Terex Corp. (NYSE:TEX) is one of the cases where buying a LEAP option might make sense. Despite the stocks impressive rally from its 2008 lows, the company is still waiting to benefit from the cycle improving. The company's management, who have demonstrated their competence in spades during the economic slump, have repositioned the company for significant growth. Terex shares trade for $28 giving the company a P/E of under 12. This is a significant discount to other names like Caterpillar (NYSE:CAT). (For more, see Companies With Huge Profit Expectations.)
At $28 consider the Jan 2012 $35 call for $2.15. This gives you the right to buy TEX at $35 anytime before the third Friday in January of 2012. At this entry price, shares in TEX would have to exceed $37.15 to break even but after that, leverage kicks in. If shares in TEX are at $40 this time next year, the option is worth $5, more than double your investment. Anything below $35 and the option expires worthless.
Trading at 60% of book value, Bank of America (NYSE:BAC) trades at the widest discount book amongst the big banks. Wells Fargo (NYSE:WFC) by comparison trades for 130% of book. One might consider playing an improvement in the operations of Bank of America by buying Jan 2013 $20 calls for about $0.90. That gives you two full years for Bank of America to clean itself up. If book value were to remain unchanged and shares trade at $25, a slight premium to book, the option would be worth $5, or more than 5 times its current value.
Investing in long-term call options can lead to an out sized payoff if they are used prudently and opportunistically. The potential loss of 100% of capital invested also means that they should only be used in the rare circumstances where the upside potential is significant. (For more, see Getting Acquainted With Trading Options.)
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