Call Options Allow Cheap Bets on Market Recovery

Maybe this isn't the best time to talk about the positive aspects of leverage and derivatives. After all, Thursday marks the one-year anniversary of the Dow Jones Industrial Average hitting its all-time closing high of 14,146. It's sunk a deep, dark 35% since that giddy day. Over-borrowing and exotic financial products are to blame.

It's fair enough if long-term value investors who've seen their nest eggs decimated by the financial crisis greet the idea of options with scorn (if not with an outright punch in the mouth.) They're complicated, risky derivative products used by pros and by active traders to magnify gains and hedge against losses. Oh, and they add to commission costs.

As such, mostly we steer clear of options. They don't much fit with a strategy of dollar-cost averaging into buy-and-hold positions. As Jud Pyle, chief investment strategist at Options News Network, says: "Options are for people who don't know which way a stock is going. Long-term investors, by definition, know it's going up." Given enough time that same strategic faith could make dabbling in options a remunerative way to bet on an eventual recovery

True, it's hard to imagine any such thing now. We're a year into this hairy bear market and conditions seem gloomier every day. An extraordinary concerted effort on the part of central banks worldwide couldn't get credit markets to budge. Fundamentals are deteriorating. The government is doling out billions by the score to no discernible effect and the market has yet to find support, despite what the technicals say.

Every natural human impulse says stay on the sidelines in the relative safety of cash, waiting for a bottom to be definitively found. That, of course, is market timing, which is a fool's game in our book. For truly long-term participants, now is the time to buy. No one wants stocks when everything is going to hell — that's why they're cheap.

And yet we can't help wanting to be stingy with our cash. That's where call options come in. Call options give you the right to buy a security at a certain price, known as a strike price, on a certain date. Call buyers pay a fee, or a premium, for this right. The premium fluctuates based on many variables, but it's invariably a fraction of the value of the underlying security. If the security's price fails to rise far enough above the strike price by the expiration date to make the trade profitable, then the call option expires and the call holder is only out the premium. (For more on how options trading works click here.)

To make a bet on the broader stock market rising, you'd buy long-dated call options on the SPDR Trust (SPY), an exchange-traded fund that tracks the S&P 500 index. The SPY currently trades at about $97. December 2010 calls with a strike price of $100 cost $14.70. That means if the stock market (and subsequently the ETF that tracks the S&P 500) is up appreciably two-plus years from now, then you could buy the SPY at $100, even though it would be trading at a much higher price. Of course, should that revival fail to transpire, you would have nothing to show for the premiums you paid. Remember, a call option that falls short of its strike price expires worthless.

Judiciously put to use, that risk just might be worth taking. A 33% drop in stocks needs to be followed by a 50% gain in order to get back to even. We'd never advise on doubling down, but the longest dated calls give the market more than two years' time to tame the bear and a little bit of leverage will help you make up some of today's deep losses sooner.