How to Lower Your Investment Risk

The DOW threatened to take out support at 12,000 in recent sessions. Stocks in general have not been able to sustain their gains following upside moves. The DOW at 13,000 and NASDAQ at 2,500 are perfect examples of selling on rallies. It is this recent decline in the markets that shows why it is important to have some kind of risk management system in place. This could be stop-loss orders or simply taking some of the profits on stocks that have made major moves.

But some of you who do not want to miss a potential sustained upward move in the market, but at the same time don’t want to be left vulnerable to selling, may look at managing your risk by buying call options to bet on the stock rather than buying the stock outright.

With the uncertainty in stocks, you want to minimize the risk and control the capital that you want at risk. The answer could be Long Term Equity Anticipation Securities or LEAPS, if you are long- term.

LEAPS are call or put options characterized by a time to expiry of more than nine months to three years from the time of purchase. The extended time period allows your strategy to play out. The only disadvantage is the larger premium that you need to pay for the LEAPS. Therefore, the stock would have to rise or fall much more than shorter-term options in order to make money. Versus holding the same amount of the actual stock, the risk is much less due to the leverage involved in LEAPS and options in general.

Advertisement

Let’s say you like chip-maker Intel Corporation (NASDAQ/INTC). You like the stock for the longer term, but want to manage your risk. In this case, LEAPS would make sense.

For instance, you could play 100 shares of Intel for a fraction of the cost by using LEAPS. Let’s say you are interested in 100 shares of Intel. Trading at $22.26, the capital outlay would be $2,226, excluding commissions. But, alternatively, you could buy one contract (each contract represents 100 shares) of the in-the-money January 2010 Intel $20 LEAPS for $525.00.

For less than 25% of the total capital required for the stock position, you could partake in the move of the same number of shares via the Intel LEAPS.

The upside breakeven is $25.25 ($20 strike plus $5.25 premium). As long as Intel breaks $25.25 by January 15, 2010, you will make money. Intel has an average one-year price target of $26.63; therefore, reaching $25.25 in about 18 months is realistic, assuming that the company continues to show advancement. On the other hand, if Intel begins to sink, your capital risk is far less using LEAPS.

For the more conservative investors or option traders, LEAPS provide an excellent alternative to a “buy and hold” strategy because of the leverage involved, as well as the management of risk.

The correlation between LEAPS and the underlying stock and the fact that it has a long shelf life makes it an increasingly attractive vehicle for the more conservative investor. In general, LEAPS call (put) option on stocks will move up (down) dollar-for-dollar with the underlying stock above (below) the breakeven point.

As an investor, LEAPS could be used in many scenarios.