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The debate of risk versus reward is at the core of investment philosophy. Every investment, (even in something as seemingly-safe as a money market fund, as some investors may soon find out) is not without risk; determining the amount of risk versus potential profit determines whether investments are worth making.

I feel as though my following idea has strong upside potential with little limited downside risk.

My company is Hovnanian (NYSE:HOV), one of the troubled homebuilders, and my method is long-term options.

Here's the reasons why the options are such a great buy:

Today I purchased the super-long-term January 2010 calls at the $10 strike price. I picked up a contract at $3.60.

The stock is trading around $7.50 currently.

  • I acknowledge that there is some chance that Hovnanian, (or any other homebuilder) could go bankrupt if the housing and credit markets crumble and the US economy enters into an extended recession. Therefore, the stock (and consequently, options) COULD go to $0. I think that the possibility of that is very slim, but if it does, you'll lose $350 with 1 options contract versus $750 with 100 shares of stock.
  • The options don't expire for 25 months; by then, if the company is going to recover, it will have recovered. Theoretically, for an investor to break even, it just has to go back to $13.50 by January 22, 2010.
  • The upside potential here is enormous. Hovnanian was a $70 stock at the peak of the housing bubble, at $40 within the past year, and at $13 less than a month ago. If the company doesn't go bankrupt (which, I'm betting it doesn't), this thing could easily be $20, 30, or even $40 depending on the size and pace of recovery.

Homebuilding stocks will recover before the entire housing market does; someone who purchased his house within the past few years won't sell it next year for less than he payed. However, Hovnanian, which will be able to buy up cheapened land, can build new houses, sell cheaply, and turn a profit.

During the past quarter, Hovnanian took a huge loss writing down land, homes, and land options. I think that their books are already pretty sterilized; people already know how badly the housing market and homebuilders are doing.

So if Hovnanian's back to profitability in a year, you'll have a $15-25 stock with a year of time value left in your options. If it does bankrupt, you'll have lost less money than if you had purchased equity.

The prospect of making 200% or maybe 500% in two years while sacrificing little is an opportunity that should be seized. The worst may not yet be over for homebuilders, but I'm comfortable with the current risk-to-reward ratio.

Especially since there's a FOMC (Federal Open Market Committee) meeting on December 11th, there's a definite possibility for a quick pop. But my money says, in two years, homebuilders will have recovered significantly. If I'm right, the reward will be considerable.

Disclosure: Author is long HOV.

Source: Rolling the Dice on Downtrodden Homebuilder Hovnanian