(FORTUNE Magazine) – There are few places safer than the sidelines. Rarely do fans get body-slammed by 350-pound linebackers, cleated in the face by base runners, or hit in the skull by hockey pucks. It is the same with the stock market. Your chances of losing your shirt on some biotech or other risky equity such as, ahem, Citigroup or Disney are nil if you're keeping your money in your mattress. But then again, the sidelines aren't much fun either--and for anyone hoping to retire on 401(k) money market funds paying 1.4%, it may also be a riskier place than you think.

The good news is that there is potentially a safer way than traditional stock investing to profit from any significant run-up in the market or individual stock. And that's options trading. Admittedly, the financial instruments with the "Do not try this at home" names ("married puts," "straddles") still carry the scent of danger. The truth is, however, they can be a less treacherous way for investors to wade back into the market's roiling waters--and more important, to limit their depth from the outset. That's because options, when done right, let you see the extent of your potential losses and gains right from the start.

And at the risk of dampening the intrigue of this story, options are no longer the exotic fare they once were. Since the late 1990s, the average number of options contracts cleared every day has more than doubled, to 2.9 million, and trading volume is expected to grow at a compound annual rate of 17% over the next five years, according to research and advisory firm TowerGroup. While most of that increase is due to institutional investors (think hedge funds), retail investors account for a significant chunk too.

The key for small investors, though, is to keep your options strategies simple and conservative. And remember, options let you limit risk, not eliminate it. With that in mind, here are five straightforward ways to hedge your bets in both a rising and a falling market.

1. Buy a call

This is perhaps the most basic options strategy. A call gives you the right--but not the obligation--to buy a stock at a set price ("strike price" in options-speak) on or before a set expiration date, anywhere from one to nine months hence. The price of the call, as with all options, fluctuates daily and is set by the market based on such factors as the volatility of the underlying stock and the time before the option expires. (Your broker can give you a quote.)

Buying call options, of course, is no more a sure thing than buying shares of any old stock. But it is a way to participate in an upward price movement without risking the full cost of the stock. As Marty Kearney, an options instructor at the Chicago Board Options Exchange, puts it, "Why buy a stock when you can lease it?"

Let's say, for instance, that you're still bearish on the overall stock market, but you believe that the financial sector--beaten down by all the revelations of slippery behavior and outright impropriety--has seen its market value overly depressed. You rattle off a few facts: Earnings multiples are no longer as hyperinflated as they were in the go-go '90s, a business-friendly GOP has control of the House and Senate, and many respected market watchers say we may have finally hit bottom.

If there is a Wall Street rebound, you think behemoth Citigroup (C) might stand to reap the biggest gains. It is trading at about $36 today, down from $46 in April. If you think the stock will rise very soon, you can buy a pair of call contracts for 200 Citi shares (options are always sold in blocks of 100) that expire in January 2003 and have a strike price of, say, $40 per share. Cost for the two contracts--that is, call options on 200 shares--is about $160. For that $160, plus brokerage fees of $1 to $6 per contract, you get the option to buy 200 shares of the stock at that $40 price anytime between now and the third Friday in January (all options expire the third Friday of the stated month). This is a so-called out-of-the-money call, because the strike price at which you're buying the option is higher than the current cost of the stock.

With calls, your upside is virtually unlimited. If your intuition proves correct and the stock quickly rises from its current $36 to $40 and then some, you'll make money. Were Citi to hit $45 (and you exercise your right to buy 200 shares at $40), you've gained around $830, after figuring in options fees and commissions. If the stock soars to $60 (hey, it could happen), you'd gain close to $4,000. Not bad. You could sell those shares right away to lock in your gain. But an easier--and more common--move is not to exercise at all but simply to sell your call options on the open market for the going price.

What's the downside if you're wrong, and Citi doesn't rise above $40 by late January? You've already paid it--$160 for the contract, plus fees. Of course, only you can decide whether the tradeoff is worth it. It may be a calculated gamble, but it is a gamble nonetheless.

Let's look at a company in another sector: retailing. Back-to-school sales figures were dismal, and the holiday season doesn't look a whole lot better. But you may have reason to be less ho-hum about the long-term outlook for the sector. According to Ned Davis Research, retail stocks have made substantial gains in the 12 months that followed the past three recessions. Several retail stocks look as if they've been marked down for the day-after-Christmas sale. Gap (GPS), for example, which hovered at $40 a share during early 2000, is now trading around $14. You think the stock will move higher eventually but not anytime soon. In that case, consider buying LEAPS (long-term equity anticipation securities). Unlike short-term calls, which expire in a few months, LEAPS last for one to 2 1/2 years, expiring in January of the year you choose (but you can exercise or sell anytime before the deadline). They are available on about 450 actively traded stocks, vs. several thousand for regular equity options. The longer your time horizon, the more expensive your option. For example, a January 2003 call contract on Gap at a $20 strike price costs about $50, but a 2004 LEAPS contract for Gap at $20 costs about $165.

What about tech stocks? You believe the tech sector has to come back eventually. But you aren't comfortable betting on an individual issue. You could buy LEAPS on the Cubes, or QQQs, the index of the 100 largest Nasdaq stocks, most of which are tech firms.

Now take the example of Walt Disney (DIS). Even if tourists don't return in droves to Anaheim, you think the house that Mickey built is far from a mousetrap. After all, Disney has a World Series-winning baseball team and a partnership with Monsters, Inc. creator Pixar Animation (which will release another potential blockbuster next summer). You don't own the stock, which currently trades at $18, 28% below its 52-week high. But you hesitate to add it to your portfolio. Why? You're skittish about the short-term prospects.

In that case, you might consider a so-called in-the-money call or LEAPS (depending on when you think the rebound will take place) at a strike price of, say, $17.50 a share--50 cents less than the current stock price. In-the-money options are generally more expensive than those out-of-the-money since the threshold for potential gain is lower. In our example above, your cost for a contract that expires in January 2004 is $380--enough to take a half-dozen friends to Walt Disney World.

2. Do a stock replacement

Defense contractor Lockheed Martin (LMT) has had a nice Rumsfeld-inspired run-up since you bought 100 shares of it in early 2000, rising from $17 to $51. You're afraid the stock may drop a bit in the next few months. But you like the company's long-term chances. In a case like this, you might use call options in what is known as a stock replacement. This strategy is useful when you're bullish over the long run on a stock or a sector but want to take a profit from a recent run-up.

Here's how it works. First sell your 100 Lockheed shares, pocketing $5,100. Then take part of that money and buy one call contract on 100 shares of Lockheed with a strike price of $50--as close as possible to the current share price. Cost: about $780 for a call expiring in June 2003. Put the remaining $4,320 into something more conservative, such as inflation-protected Treasury bills (TIPs). What you're doing is covering yourself if the stock goes up further. You've made a profit now; you've also given yourself the chance to make a profit later.

3. Scoop up a put

Martha, Martha, Martha. Perhaps you disagree with FORTUNE's recent take on the domestic diva's legal crisis (see "Will Martha Walk?" on fortune.com). Hey, it happens. Even if her current troubles turn out to be no worse than a sagging souffle, you can't believe they won't continue to skunk shares of Martha Stewart Living Omnimedia (MSO), now trading at $9. While you're lucky enough not to own the shares (they've fallen from a high of $20), you are feeling frisky enough to bet against it. That is, assuming you don't have to short the stock--the risky act of selling borrowed shares with the hope that the price will fall. (When you do that, your potential loss is unlimited.)

Have you an option? You bet--you can simply buy puts: options that give you the right to sell the underlying shares at a specific price during a fixed period. Puts limit your risk, because you know exactly how much you can lose. It works like this. If you think MSO is going the way of WorldCom, says Alex Jacobson, vice president of education at the International Securities Exchange, you might buy a put with a strike price as low as $7.50 or even $5. Cost for a contract of 100 shares at $7.50 that expire in March 2003: $120. The fee for a $5 strike is just $50. (In general, the lower the strike price, the cheaper the cost of the put.)

The $7.50 put gives you the right to sell the stock if the price falls to $7.50 or below. Say MSO falls to $6 before the put expires. You'd sell your put for, say, $150 and walk away with only a few dollars: the $120 you paid for the options, plus the broker's fee, nearly cancels out the money you made from the price movement. You've wasted your time. But if the price drops to $2 and you promptly sell, it's a good thing. If the price rises, naturally, you'll make nothing--and be out the cost of the puts besides.

4. Sell a covered call

You own several stocks that you don't see moving up significantly, but you have little desire to get out of them at this point, maybe because they're paying stable dividends. Selling, or "writing," a call against a stock you already own--known as a covered call--may be for you. "It is a very safe strategy," says Jim Bittman, who teaches options strategy at the Chicago Board Options Exchange's Option Institute. "Selling a covered call brings in some income and actually reduces your breakeven point."

Take Procter & Gamble (PG). It's a pretty stable stock, trading at around $85, and you don't see it popping much higher in the near future. You own 100 shares. And you want to generate some extra income while limiting your downside. You can sell a call through your broker for all those shares at a strike price of, say, $90, that expires in April 2003. In return you get $410. If the stock doesn't hit $90 before April, you're golden: you've made the $410 and keep the shares too. But if the price rises to $90 or above, you must sell them to the call holder for $90 per share. If the shares hit $95, you've lost the $5-a-share upside.

Covered call writing can be great in a lackluster market like this one, says Kearney. But, he cautions, "it is not good in rapidly rising markets because it underperforms. You still make a profit, but not as much as you could have."

5. Read the options stars

If options trading sounds like a huge hassle to you--and without question, it takes some time, research, and nerve--don't write it off just yet. Even if you don't want to start tossing around puts and calls, you may benefit by looking at options-trading data. Movements in trading volume and volatility might help you predict the moves of the broader market, say some experts.

There are two key indicators to look at. The first is the Chicago Board Options Exchange's volatility index, known as VIX, which tracks volatility levels of a bundle of S&P 100 options. To find it, go to the CBOE's website (see box). "The basic theory," says Lawrence McMillan, president of investment research firm McMillan Analysis, is "that when the market is declining rapidly and at the same time VIX goes shooting skyward and makes a peak--a spike peak--then that's a buy signal." That's because increased volatility often correlates with increased investor skepticism--and when everyone is bearish, it could mean a bottom is near. The second indicator is the equity put-call ratio, which tracks options volume and can also be found on the CBOE Website, among others. As with the VIX, many traders interpret a sky-high level of put-buying as a sign that the bears are out in force. In the perverse rules of the market, that could signal a buy.

Both gauges have predicted past bull markets and shorter-term stock run-ups. For example, on July 23 the VIX hit 50--the level that some analysts say predicts a rising market. Sure enough, the S&P 500 began climbing, rising 14% over the next six days. In October it happened again: the VIX hit 50, the S&P bounced up.

These indicators aren't foolproof, however. Jacobson, a former Merrill Lynch broker, says he distrusts them. And Kearney cautions that they "should only be used in conjunction with other indicators," such as P/E ratios and interest rates, when making investing decisions. After all, just because you've left the stock market sidelines doesn't mean you want to get pummeled.