Protecting Stock Profits: Here’s the Breakdown of the Ultimate “Safety Net” Trade
by Karim Rahemtulla, Options Expert
Wednesday, February 17, 2010: Issue #1198
Petrobras (NYSE: PBR) – a giant Brazilian oil company and one of my favorite holdings.
Last spring, I bought 1,000 shares for around $20. As of last week, the shares had doubled in value. Great news, right?
Not so fast. Level-headed investors know that this is a jittery time. Hold on, set a stop-loss, or sell? Those are the choices that most investors face when it comes to protecting stock profits. Let’s run through the scenarios…
If You Have Existing Stock Profits, Here’s What to Do Next…
- Scenario #1 – Hold the Shares: Having bought 1,000 shares for $20 a pop, I’d be sitting on $40,000.
- Scenario #2 – Set a Trailing Stop: If I set a trailing stop of 25%, I’d sell at $30 from the $40 level. But that means I’d stand to lose $10,000 of the profit.
- Scenario #3 – Sell the Shares: If I choose to sell the Petrobras shares outright, there’s always that “what if?” pang of potential regret. What if oil heads higher? What if Petrobras shoots back to its most recent high over $50? Am I leaving money on the table?
No one is ever sorry for taking profits. But a good investor is savvy, disciplined and has more than one way to make money. And there’s a way for you to have your cake and eat it, too. Here’s the strategy that can make it happen…
The Breakdown of the Ultimate “Safety Net” Trade
Given my previous columns about how LEAP options are a great way to significantly boost your upside… invest far less money upfront… and give you the luxury of time for the trade to play out in your favor, you may be asking why I didn’t buy LEAPS on Petrobras in the first place.
Well, I did. But it wasn’t until after I’d bought the shares, during the heat of the sell-off when few people wanted to buy shares. That’s because when the market was extremely volatile, the asking prices for PBR LEAPS was absurdly high. So bad, in fact, that it was actually better to buy the shares.
But when the options volatility declined, here’s how the trade shook out:
- Sold PBR shares.
- Bought in-the-money $30 LEAP calls, which expire in two years. Those options cost $13 per contract ($1,300 per 100 shares), giving me the right to buy 100 shares at $30 per share any time between now and expiration.
- By buying in-the money options, I paid the least amount of premium for time and for risk – $3 ($30 strike + $13 total outlay per contract = $43). Because the stock was trading at $40, $43 minus $40 means the net premium I paid was $3.
- I ended up spending $13,000 on the new LEAPS position. But remember, if I’d simply held the shares outright, my stop-loss was $30 – potentially losing out on $10,000 in profit.
- So while this position costs me only $3,000 more, I’ve taken $27,000 off the table to reinvest elsewhere. That’s almost 75% of risk eliminated, while having unlimited upside potential. Pretty compelling.
Cash Out… Stay In… Sleep Better
Take a look at your portfolio.
If you have hugely profitable positions, consider taking anywhere from 70% to 90% of the risk off the table by switching your regular stock holdings to LEAP options instead. By doing so, you’ll have two full years to control the shares and remain in the company. I guarantee you’ll sleep better, knowing that the vast majority of your cash is not at risk in the market.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
- Potentially Grab Portfolio Gains Without Buying Shares or Risky Options
- LEAP Option Investing: Know These Five Factors Before Using This Strategy
- Three Ways to Safeguard Your Investment Portfolio
- How to Sell Put Options and Snag the Market’s Daily Deals
4 Responses to “Protecting Stock Profits: Here’s the Breakdown of the Ultimate “Safety Net” Trade”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
I have 3 stocks with 100% plus gains. But if i sell them before one year is up Ihave to pay 30 % plus capital gains tax. What do I do?
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Sell the out of the mony covered call and use the proceed to buy atm put option purchase may be very little debit.3month expiration each time you write the option.
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Good option but a better option is to sell your shares lock in 20 profit and just sell naked puts stk at stk of 40, your upside is premiun of the puts downside is new entry point for PBR low 30′s which is probably a good buying opportunity..Also you could buy otm calls in the 50′s to have additional upside.. The one thing I don’t like about your strategy worst case gain is 7K..Of course all strategies should be adjusted to reflect the mkt conditions as you did in 3/09. a better option instead of buying the stlk would have been sell in the $$ puts if premiuns are high better to be a seller then be a buyer
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Karim is certainly the expert on using LEAPS calls and I am excited about the strategy so I bought Jan. 11 $40. Calls on VALE for .70 and $50. CALLS for .20 and 2012 $40. calls for $2.23 which is not a big investment for the potential for VALE to rise near its previous high over the next 2 years.
There are probably dozens of prominent companies that fell hard in late 2008 that could be good LEAPS candidates, and the risk/reward factor for people with limited capital should be quite good compared to buying shares in the $50. to $100. range
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