The equity market has been on fire in 2013, and nearly every investor I know is sitting on big gains in at least a few of their positions. In fact, most investors I know have multiple winners sitting in their portfolio — winners they don’t want to sell because they believe in the company and its growth prospects. Of course, the spike higher in stocks in recent months is something that everyone fears could come to an abrupt end … or worse, could see a sharp reversal of fortune virtually at any time.
Indeed, the testimony to Congress by Federal Reserve Chairman Bernanke on May 22, and the introduction of “tapering” into the trading lexicon, already has prompted nervousness in the market. That nervousness has shaved off about 3.5% of the S&P 500’s value since. It’s also caused a significant spike in the long-term Treasury bond yields, and that too has unnerved the bulls.
For investors who hold some of the biggest and most liquid winners the market has seen in recent months, there are three basic ways to protect yourself.
First, you could simply sell the winners you have now and bank the gains. While this isn’t a bad strategy, it could leave you with a short-term capital gain that you’ll have to pay high taxes on. Worse yet, you will no longer own a stock that you might believe has more upside in the months and year to come.
A second way to protect yourself is to set a trailing stop on your winners that essentially kicks you out of the stock if it falls down to a certain level. This will keep you in the stock until it does, in fact, fall. However, you still might face the same situation of holding a short-term capital gain and being kicked out of a stock you actually like.
Perhaps the better way to go about securing your gains is via an options strategy called buying protective puts.
Think of this strategy as buying portfolio insurance. You really don’t want to have to use it, but if you do need to use it, it can give you a little added portfolio boost.
Here’s how protective puts work:
First, you take a winner (a stock you have a big unrealized gain in), and you buy a put option on that winner. That put option gives you the right to sell the shares at a certain strike price. Here you will want to pick a strike price where you will be willing to sell the underlying stock if the price falls to that level.
The next step is to pick an option with an expiration date that’s dated far enough so it doesn’t suffer from what’s called the “decay rate.” Basically, when buying protective puts, you want an expiration date that expires at least a few months from your purchase date. You also will want to choose an out-of-the-money put (a put strike that’s below the current stock price).
So, if your winner’s price falls below the strike price, you can exercise the put at expiration by selling your shares at that put’s strike price. Of course, the cost of the put will factor into the equation and shave off some of your profits, but the good thing is that if the stock were to plunge well below your strike price, you won’t suffer that decline.
Moreover — and this is the good part — if the price of the stock falls, you also can sell the put before it expires, and you might even get a gain on the sale of the put depending on the price action in the shares.
Here’s an example trade on a high-flier, Micron Technology (MU), which has improved more than 30% in the past three months:
Say you bought Micron shares around the $9 level. You want to lock in gains of at least $1 per share — especially if the stock were to begin tumbling from Thursday’s closing price of $12.91. Plus, you’ll also want the opportunity to make some money if the price falls. Here a protective put — such as the out-of-the-money MU Oct 2013 11.00 Put would work. Your cost here would be about 80 cents, which means your breakeven price is about $10.20. That means you’re still going to make $1.20 per share if you exercise the put at that price. If the price of MU shares were to fall, but also stay above $11, your put will appreciate in value sharply. Then you can sell that put at a profit while still remaining long the stock.
Now, there are many candidates out there that qualify for this protective put strategy, so a complete list is pretty tough. However, there are a few stocks that I see that could be good candidates for this strategy, as they have run up big during the past several months.
In addition to Micron, here’s a short list of stocks that might fit the protective put bill (along with their respective three-month price performances) if you currently hold big gains in each:
- Apollo Group (APOL), +25.4%
- Best Buy (BBY), +28.2%
- Bristol-Myers Squibb (BMY) +21%
- Monster Beverage (MNST), +31.5%
- TripAdvisor (TRIP), +20.6%
The strike price of the options on these stocks, the costs and the strategy will depend on where you are with your holdings. So make sure you run the numbers to see whether they work in your favor before you decide to buy protective puts. If the math works out to your favor, and if you are willing to pay for a little insurance to protect your gains, then this strategy could definitely help you profit.
As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.