How to Keep Your Capital Safe

by George Leong, B. Comm.

There is above-average risk in the current market — I feel there continues to be the risk of a downside move towards the lows. Of course, I could be wrong, but, again, why take on more risk than you need?

Say you like a company and believe it’s set for a rally. You buy the stock, but, unfortunately, the stock fails to move up and instead declines rapidly after weak earnings or a slide in the broader market. The end result is that you lose more capital than you would have liked. To help minimize trading losses, a simple strategy you can use is the employment of call options on the underlying security.

The rationale for buying call options is simple. You would buy call options if you were bullish towards a stock, or a group of stocks, as in the case of an index call option.

The buyer of a call hopes the price of the underlying security rises past the breakeven level before the expiry date. Under this scenario, there are two strategies. The call buyer can sell part or all of the calls for a profit prior to the expiry date. Or the call buyer can exercise the option as per the terms of a call option and acquire the underlying instrument from the writer of the call at the strike price. At this point, the call buyer can now keep or sell the acquired instrument.

For example, say you believe the tech sector was primed for a turnaround. Given this assumption, you could buy call options on the NASDAQ 100 (QQQ) Index, which tracks 100 major tech stocks on NASDAQ.

Call options can also be used in special trading situations, say when there’s speculation that a company might be primed for a takeover. In a case like this, you would buy calls on the takeover target and hope your hunch was right. If correct, you could walk away with hoards of cash. The alternative for many investors would be to buy the target company, but unless you have lots of capital, it does not give you the leverage that options offer to the average speculator.

Let’s take a look at an example. Let’s say you like Microsoft Corporation (NASDAQ/MSFT) at the current $19.93 as of April 28. You can buy the stock or the call options. Say you buy the out-of-the-money July 2009 $21 MSFT Call, paying a premium of $0.93 per share, or $93.00 per contract. The option expires on July 17, 2009.

With the premium of $0.93 per share, the breakeven is the strike price of $21.00 plus the $0.93 premium paid, which equates to a breakeven of $21.93.

Leverage is an important advantage of options. For instance, with Microsoft trading at $19.93, you’d need $1,993 to buy 100 shares. But a similar reward profile can be achieved by buying one Microsoft Call contract for $93.00, which is also the maximum risk at stake. You cannot lose more than $93.00, whereas you could lose up to $1,993 if you buy the stock and it declines to zero. In reality, Microsoft will not go to zero, but say it declines to $15.00 over the next few months. If you bought 100 shares, you’d be down $493.00. The Call option alternative would cost you a lower $93.00 under this scenario.

This is a key advantage of options — you can manage the risk and know how much you are willing to risk.

Moreover, if Microsoft surges, the percentage return of your leveraged Call option trade would be superior to the holding of the stock.

Options are another investment alternative definitely worth a look.