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By: Costas Bocelli — November 11, 2010

How to Protect Your Stock Profits

Editor’s Note:  Costas is out today, but returning next week as usual.  Please enjoy the below article, originally published in April and once again useful given recent market action.

 
 
The biggest fear investors have when initiating a position is the fear of losing their principal.  The "paralysis by analysis" effect may even become a factor when deciding to pull the trigger.  This is a common emotion, and I am sure you have experienced this anxiety from time to time.
 
The next biggest fear for stock investors is the fear of losing profits.  That’s right, profits.  After you pull the trigger on the trade and the stock price trades favorably, your gratifying pleasure begins to turn into impatient paranoia.

Remember, a profit is only realized when you actually sell.  The profit you have is in virtual paper profit land, a far different place than Planet Reality.

Let’s say you bought a stock in early 2010 for around $65.00, and today it is trading at $77.75.  You are currently sitting on an unrealized $12.75 gain.  This is a nice position to be in obviously, but remember, the position is still open with your profit and principal at market risk.

Let’s fill in a little more detail and add some real world perspective to this.  The stock you bought in mid February 2010 for $65 a share is Boston Properties, Inc. (Sym: BXP).  BXP is a real estate investment trust that has participated greatly to the upside in the current bull market. 

With the stock near its 52 week high, BXP is set to announce earnings tomorrow, Tuesday April 27.  There is still uncertainty looming regarding the recovery of the commercial real estate and credit markets.

Do you think that your profits and principal are at risk?  There is a degree of uncertainty as to what the earnings will be, how the market perceives the reports, and more importantly, what management has to say in the conference call.

If you prefer to continue holding the stock if possible, but are anxious going into an uncertain event such as earnings, there is a way to protect most of your profits, insulate your principal from any loss, and have the potential for additional profit. 

All this can be accomplished by using a simple option strategy called a “Collar”.  The strategy cost can be very cheap, free, or you may even get paid for the protection in some situations. 

A Collar is designed to protect you from the possibility of large negative price movements, thus protecting the position long enough for you and your stock to digest the earnings report and the market action.  A collar is the purchase of an out of the money PUT for protection while simultaneously selling an out of the money CALL to finance the cost of the PUT.  Both options are traded in the same month, and in this case, you are looking for protection for April 27, so you want to do this in the front month May expiry.  Your insurance policy will expire on May 21, the third Friday of the month.

How to Create the Collar on BXP

With BXP trading at $77.75, you can buy the MAY 75 PUT for a 1.55 debit and sell the MAY 80 CALL for a 1.55 credit.  The insurance policy can be set up for free, outlaying 0.00 (broker commission charges only)!  Buying the PUT gives you the right to sell the stock at $75, and selling the CALL obligates you to deliver your stock at $80 if you are assigned.

What is this insurance doing for me, and what effects can it have on my position?

There are basically 3 scenarios that can happen ...

Scenario 1, The non event:
  After the release of the earnings report and management statements, the stock price has no affect in the market, essentially staying unchanged around $77.75.  Since the insurance collar cost you 0.00, you can either keep the collar on until expiration, or you can trade back out of it for close to what you paid, 0.00.  The result was free protection going into earnings.

Scenario 2, The stock negatively sells off:
  If the stock trades below $75, your PUT protection kicks in, insulating any losses below 75 (The PUT gives you the right to sell the stock at 75).  If the selloff is severe with a drop of say 9% that would put the stock price around $70.  The collar saved $5 dollars of profit, though you still lose the profit from $77.75 to $75, but that is it.  The unprotected stock position would have cost you almost $8 in profit.

Let's say the stock experienced a more likely selloff, perhaps in the 3-4% range, putting the stock around $75.  This result still has more benefit than not using the option protection.  With the stock stabilizing or settling in at $75, your stock profit is reduced by 2.75, however, the collar position increases in value with the decline in stock price.  You will find that you can sell out your collar position for about 1.50 credit (remember, you put it on for 0.00), offsetting the 2.75 loss from the drop in stock, reducing the loss to only 1.25.  You can think of the 1.50 credit as a reduction to your stock cost basis from the purchase price of 65.

Scenario 3, The stock trades higher:  Have you ever heard the expression, “There is no such thing as a free lunch”.  Well there is an opportunity cost to getting “free insurance” with using the collar strategy.  What you have to be prepared for is that you will not be able to participate in additional stock gains above the CALL strike you sold, in this case 80.  With the stock above 80, your upside profit will be capped from 77.75 to 80.  You can only make an additional 2.25 or 3%.  You got in at 65, but the collar will get you out at 80.

This collar strategy is ideal when you have benefited from stock movement and want to protect your profits while taking the principal risk off the table going into an uncertain event, such as earnings.  If you feel that there is a greater opportunity for more upside appreciation than downside risk, the collar strategy may not be the best risk management tool for the situation.

However, if you feel the stock has made a nice run and seems there could be a substantial risk to the downside; consider the “collar” strategy.  It may be more prudent to employ the “collar” on your stock position than employ the “strangle” to your neck if things go bad and the stock tanks wiping out profits or even worse, your invested principal.

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