Once a behemoth in cell phones (oh wait, it still is), Nokia Corporation's (NOK) share price has been in free fall for the past few years. From just over $40 in 2008, shares now change hands for less than $2.
That is one ugly chart. Will the stock find a bottom? Will the company survive? Is it cheap enough to buy here at $1.86? Finding an answer to these questions is not what this article is about. There are lots of opinions out there, ranging from "Nokia is toast!" to "This stock is the best value proposition since the settlers bought Manhattan for a handful of beads!". No one knows how this story will end, but if you do decide to take a flier on NOK, I think this situation provides a good example of how options can be useful.
The first thing I do with a prospective investment is create a story about the potential risk, the possible reward, and the time horizon. In this case, it's pretty simple. The downside is 100%, and that seems like a real possibility. It still have cash in the bank, but if Windows 8 doesn't light a fire under its smartphone sales then it's all over. If Nokia rights the ship, or even just manages to sell itself - even a fire sale - it seems reasonable to think that the company could be worth a multiple of where it's trading now. Let's say $5/share.
Keeping it simple, in this case if we want to gain exposure to a jump in Nokia's share price we can just buy the shares, or we can buy calls. The shares sure do seem cheap, but some basic math shows that the calls are a much better bet as long as we expect the dust to settle within a year or so.
Right now you can buy Jan 2014 $2.00 calls for .65 on the offer. If Nokia goes bankrupt, you lose everything, but assuming that it does get bought for its IP etc. at $5 share, you make 360% on your investment. If you buy the shares at $1.86 on the other hand, you would make 168%. That's half the return you could have had on the calls. In fact, the only way you do better buying the shares is if the company survives and the stock gets bought out for less than about $3.50. Of course, the second way you could lose would be if this little drama takes longer than another year-and-a-half to play out. Looking at Nokia's balance sheet, and given the debut of Windows 8 later this year, that doesn't seem very likely.
Right now, I think Nokia represents a binary bet: It either goes bankrupt, or it gets bought out/ returns to being a viable business. In the first case, all equity gets wiped out. In the second, the equity will be worth a multiple of where it's trading today. As long as this assumption is proven true then no matter what eventually happens, the calls represent a much better investment here than the stock.