February 28, 2013 at 05:29 AM EST
Big Risk? Try This Strategy

Try This StrategyIn technical analysis, the chart tells a story. On Monday, the S&P 500 closed below 1,500 for the first time since February 4, driving fears of a multi-year topping, which I have discussed in the past. (Read “Alert: Bulls Should Be Careful Despite an Impressive January.”) The Dow Jones failed to hold above 14,000 for the third time over the past several weeks. With the decline, the NASDAQ, Dow Jones, S&P 500, and Russell 2000 are back in negative territory for February, with the final trading session taking place today. The trading is similar to what we saw in 2012 following a positive start, and 2012 turned out to be a year of caution, so you need a prudent investment strategy.

Currently, we have the $1.2 trillion “sequestration” budgetary cuts set to take effect tomorrow. The automatic $85.0 billion in annual budget cuts could have a widespread impact on the country and the economy, including program cuts, job losses, and chaos.

Face it; the country’s money printing presses are stopping. The Federal Reserve suggested the possibility of needing to reduce or stop its $85.0 billion in monthly bond purchases. The Fed’s bond buying has added further liquidity into the economy to keep it going. This has also been the case with numerous central banks around the world. The problem is that the monetary easing has created an artificial economy that’s supported by the printing of money.

Then there’s the political uncertainty in Italy, where the outcome of the national election could determine which path the country takes as far as economic reform. The concern is that Italy is the third-largest member of the eurozone, and problems here could cause more havoc.

Given all of these uncertainties, there is ample risk in stocks, and you need a good investment strategy.

You can buy into new positions and assume the risk of a market correction, but a much safer and more prudent investment strategy alternative is to play the upside via the use of call options. This would allow you to take advantage of any upward move in the equities market, while also managing the maximum risk you have via this option investment strategy.

Let’s say you feel the economic renewal will continue to drive auto sales, but you are worried about a possible economic downfall given sequestration and Europe’s economic mess.

You like what Ford Motor Company (NYSE/F) is doing and feel the stock may be heading higher. But instead of buying the stock outright, you can play Ford via call options to add leverage and also limit the loss to the premium paid, which is a good investment strategy.

F Ford Motor Co. stock market chart

Chart courtesy of www.StockCharts.com

Let’s take a look at Ford and assume you want an option investment strategy that equates to 1,000 shares of Ford. You feel Ford could rally to $15.00 by December 2013.

Assuming this, you buy 10 call contracts of Ford, equal to 1,000 shares of the underlying stock. You are looking at the December 2013 expiry for the Ford in-the-money $12.00 call for a premium of $133.00. The cost per contract of $133.00 equates to $1,333 per 10 contracts, which is the maximum risk under this investment strategy. If Ford fails to hold at $12.00 by the December 20, 2013 expiry, the premium you paid is lost in this investment strategy. The upside breakeven is $13.33, which is pretty good, given there’s a good chance Ford will trade above this level by the expiry.

Now, say Ford jumps to $15.00 by the expiry; you would make $1.67 per share, or $1,670 for the 10 contracts, for a leveraged return of 125% in less than a year under this investment strategy.

The maximum risk is $1,333, but you more than double your money if Ford moves up to $15.00 by the expiry, which is a good risk-to-reward investment strategy.

You can apply this Ford example to many stocks that may interest you as a lower-risk investment strategy alternative to buying the stock, especially given the current market risk.

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