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Kirk Spano

Sept. 25, 2013, 1:14 p.m. EDT

Three calls with big upside

By Kirk Spano

Two weeks ago, in Build your own hedge fund, I discussed some simple ways to limit risk on your stock portfolio. Today, let's explore a leveraged, but low-risk way to maintain exposure to our volatile high-ceiling ideas.

Buying call options generally strikes fear into the heart of most investors. The main reason is that even when we are right about our ideas, if we do not have good timing, then we can still lose money. The trick to using calls is to not overextend on risk through buying positions that are too large for your portfolio size.

For example, while I will occasionally buy up to 12% of my portfolio in a single stock, Apple being the latest when it was around $400/share, I will generally not put more than 4% into a long call option until I have booked some profits and have momentum on my side.

Buying call options starts with finding a few companies that have catalysts which are likely to drive gains in the stock sooner rather than later. I generally like to have three to five call options open for 6% to 20% of my portfolio. I often have no call-option positions if pricing or market conditions are not right. Sometimes I will have a significantly larger total call position, generally after significant stock-market corrections or if momentum is allowing me to expand positions out of profits. In general, I trade calls around an intermediate- or long-term stock position, looking to enhance my stock gains, not outright speculate.

Here are three companies that have potential for big gains due to catalysts particular to their businesses. Each also has their own particular risk, which is why the call options are attractive over buying more stock. In these cases, and similar, we can add exposure without committing large sums of money. If a catalyst or catalysts hit positively in the time frame of the call option contracts, we can see multiples on our money.

The first company that I own calls on is SunEdison . SunEdison is a solar company focused on engineering, procurement and construction of solar projects. They are also one of the developing leaders in solar financing, which seems to be promising large long-term free cash flows once critical mass is reached.

On a down day, I bought the April $8 strike price calls for a $1.50. Taking this position gives me two earnings calls plus a little time value after the February earnings before contract expiration. To me, that was worth the slightly higher price for options eight months out. Most option traders will trade nearer-dated options because they are looking at small short-term moves. With this trade, I am looking for something bigger.

Should the stock rise to $11 by April, I will make a 100% gain on the position, at $12.50 I make 200%. You can see the leverage effect. If the stock is between $8 and $9.50 I will recoup some of my 1.50 premium commitment. If the stock is below $8, I lose the entire investment, which is 2% of my overall portfolio.

The second company is a heavily shorted biotech, (NAS:EXAS) , which I am very familiar with, having followed it for six years. The company has a non-invasive screening test for colorectal cancer before the FDA right now and is likely to get a determination by spring. It is my expectation that the product is approved by the FDA and that CMS (Center for Medicare and Medicaid Screening), which has agreed to a parallel review with the FDA, approves it for reimbursement at a fair level. If Exact get positive news, by early next year it could reach the upside that Barron's suggested it has, which is over $20 per share. Currently the stock trades for about $12.

I own the Exact January $16 calls with a price paid of $1. I also own the $14 and $15 January strike prices. I will roll those out to April or later should determinations not come by January. Interestingly, somebody has taken a huge January $16 call position with 10,000 contract controlling a million shares. They appear to have a corresponding position in the January $16 puts.

The third position is in Barrick Gold . I was a guy who told folks that gold prices had peaked, and then reminded gold bugs about it here — because they are so fun to remind of things like that. I am still not a bull on gold prices, however, I am not terribly bearish anymore either. What I do know is that the gold-mining industry is priced pretty low.

We are now seeing some gold mines shuttered and some gold mine projects pushed out or canceled altogether. Eventually, the gold miners will benefit from reducing the supply of new gold and encouraging gold prices to drift up again. There is also the always real possibility that inflation, fear or crisis drives gold higher which could push miner prices up as well. Barrick in particular is right-sizing their ship under a new CEO, and its share price is much closer to its bottom than top. Should a macro factor or Barrick doing something to make Wall Street happy — such as selling a large asset — occur, Barrick could see a sharp quick share price rise. I own the April $20 calls on Barrick Gold.

Disclosure: Clients of Bluemound Asset Management, LLC own calls and stock in Barrick Gold, Exact Sciences and SunEdison. No trades are planned in the next three days. Opinions subject to change at any time without notice.

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