Choosing the Right Options Play

Equity options open up a world of opportunity. You can act on almost any opinion you have about the movement of a stock through an options position. So let's explore a recent scenario where using an options position would be far superior to a long or short stock position, as well as a few key items to watch.

In a recent article, I wrote that Apple Inc. (Nasdaq: AAPL) was under-priced at $325, and suggested the stock should really be valued at more than $400/share. (See Awaiting Apple's Breakout.) I was concerned about weakening momentum and volume on rebounds off of the $325 threshold, but wanted to take advantage of the upside if it broke out of its channel. Buying the stock at $325 and protecting the downside by buying a put option at the $325 strike price would cost you an additional $17 for "insurance" through September. Your breakeven for this typical strategy would be $342, essentially a 5% fee for full downside protection.

Instead, I would recommend buying a January 2012 call north of the breakout signal -- at $355, where it would really capture the full value of positive momentum, but still be cheap enough to be attractive at $18. You could then help finance this by selling the same-month call at $400 for $7, effectively creating a spread that would capture the full value of your anticipated price movement for $11/share. If Apple stock goes to $400 (or higher), you net a 309% return, where the same stock movement with downside protection would only give you 17% return.

Additionally, the spread only consumes $1,100 in at-risk capital for the benefit of the movement of 100 shares of AAPL stock through January. The stock-plus-put purchase would tie up $34,200, and your max total loss is still higher at $1,700. To me, this means that I can further diversify my portfolio and broaden my exposure, as less capital is committed to each movement. I don't recommend leveraging to "spend" the same amount (buying 30x as many options contracts to match the alternative $34,000 investment), because 100% of the spread is lost if the stock fails to move up.

To use options most effectively and profitably, I believe you need to have all the elements of any well planned stock purchase, plus a thorough understanding of the leverage and risk you're taking on:

Price target. What is a share worth (fundamental valuation)? What will it take to move the price to that level (supply/demand, news expectations, etc.)? Does a technical analysis suggest this a good entry opportunity? These price expectations can be used to choose appropriate strike prices that minimize your cost and allow you to capture the full movement you expect.

Defined timeline. When do you expect the price-altering events to come to pass (at the latest)? Do you expect a gradual movement or a much more sudden change? If you expect a six-month gradual increase, you could buy a near-the-money call with an expiry six months from now, and sell a front-month call each month, gradually increasing the strike price of that monthly short call to maximize your profit from the play.

Downside protection. What if you're wrong? There's nothing wrong with being wrong. In fact, you can make a fortune investing while being wrong 45% of the time. But you always need to preserve your capital so when things go awry, you live to invest another day. Buying a call automatically limits losses to the cost of the call, and can provide you with many times more exposure per dollar at risk (leverage) than a simple stock purchase. You can take this additional capital and get a CD or high-yield savings or money market return risk-free, or you can use it to diversify exposure in your portfolio.

Leverage. Within a portfolio of investments, you will have some winners and some losers. Because options can be extremely high-leverage, you shouldn't allow the downside of any single option play to be a significant part of your portfolio. If you like AAPL at $325 and, instead of buying 100 shares of stock, buy $33,000 worth of calls at $330, hoping it will go up, you could lose it all if the stock only climbed to $329 by the time your option expired.

Options are amazing tools if you use them responsibly and intelligently.What else do you look for before using options instead of stock?