Long Options to Take Profits (Without Selling Stock)
Every stockholder faces this dilemma: you bought stock several months ago and recently the price jumped, perhaps even more than you ever dared hope. Now what?
The dividend yield is very attractive and you would like to hold onto shares. The fundamentals are strong and steady. You believe long-term prospects for more growth are promising. In other words, there is every reason to just hold onto shares and take comfort knowing you have made a great choice.
Even so, that inside voice is telling you to take profits right now while you can. If the stock price dips you can always go back in at a bigger bargain. Take your profits.
This is not a good idea, and the more sensible voice of reason knows it. So how do you deal with the tendency to speculate on today's price swing? The impulse makes a good argument: If you don't take profits today, they might not be there tomorrow. You've seen it before. You hesitate and you lose. So sell!
You have the opposite problem when the price falls. You don't want to have any further losses, so maybe you should sell now and cut your losses.
Conventional wisdom tells you this is the smart move if the stock is likely to continue downward. If you were wise when you picked stock, you know it is going to rebound. But still, what if it doesn't?
This is where options are so valuable.
If you have done a good job of picking strong stocks to invest in, you know that selling when price moves in either direction is not a smart move. And yet, you worry about price swings.
The solution is to play the price spikes and dips with relatively modest option positions. When prices spike, buy insurance puts (one put per 100 shares), focusing on At The Money ('ATM') or slightly In The Money ('ITM') strikes. If you think price is going to move quickly, use puts expiring within one month or less; these have the least amount of time value.
Vertex Pharmaceuticals (NASDAQ: VRTX), for example, closed on Friday, June 23, at $60.61. If you had bought at the beginning of the week at $57.50, one strategy would be to invest in a long put to protect your basis. A July 57.50 put costs 3.80 ($380). This takes your basis down to $53.70 ($57.50 less $3.80 per share), but a conservative defensive strategy like this makes sense; and you can also combine it with a covered call to create a collar and remove all of the cost from the strategy.
A July 62.50 call could be sold for 4.30, creating a net credit of 0.50 (4.30 minus 3.80), before transaction costs. If the stock slides below $57.50 per share, you can exercise the put and sell at the strike. If the stock rises above $62.50 and is exercised, you get a capital gain of $500 ($62.50 - $57.50 per share).
If the price dips but you still believe the company is a sound investment, keep shares but buy calls. Again, focus on ATM or slightly ITM short-term options. As the price rises, the call's intrinsic value appreciates point for point with the underlying.
In another example, PetSmart (NASDAQ: PETM) had dipped by Friday, June 23, closing at $66.29. If you had bought shares on Wednesday at $69.50, the dip in price could be an opportunity. A good way to play this may be to buy an August 65 call for 4.00 ($400). If the price does rebound, the call gains one point of intrinsic value for each point of upward movement.
The same swing timing can be applied using short options, but that is a topic for another time. You're playing volatility when you offset those price swings in stock by buying well-timed options. It's better than selling shares when you don't really want to. Timing volatility plays is a difficult task, and many options traders can benefit by getting valuable help. It is wise to take a look at methods for tracking IV on the stocks you own, as part of your options strategy.
A volatility-based strategy can be complex without help, but it can be simple and easy with the right tracking tools. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.
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