For most investors, the big bounce we've seen over the past month has been long overdue. But if you're not convinced that the bear market is over yet, you may want to take some of those profits off the table.
Obviously, if you were fortunate enough to pick up some shares of cheap stocks back in early March, the simplest way to lock in some of those gains is to sell them outright. If you're willing to use a slightly more complicated strategy, however, you can actually boost your profits without taking on any more risk than you're comfortable with.
It's your option
This profit-taking strategy involves options -- specifically, writing call options. You may have heard about writing call options before, in the context of a more typical covered call strategy. Usually, if you own the underlying stock, a covered call strategy has you write calls that will only get exercised if the share price rises.
That's because the usual assumption in writing calls is that all other things being equal, you'd prefer to hang onto the shares. But if you're looking to take profits on a position, that assumption is false. By adjusting the price at which the option will get exercised -- also known as the strike price -- you can essentially lock in some of your profits, even if the share price falls.
How it works
Let's use a real-life example. Say you bought shares of Apple
But let's say you're nervous that the stock might give up some of its gains. Perhaps you're concerned about its earnings release later this month, or you just think the shares will fall if the overall market corrects downward. If you sell, you lock in a $31 profit.
In contrast, look at what happens if you use a covered call strategy. You could write a call letting someone else buy your shares from you for $105 any time between now and mid-May. Based on recent prices, you'd get paid about $17.20 per share to write that option. As long as the stock price is still above $105 by next month, then the option will get exercised, and you'll end up with a total of $122.20 in proceeds from the option and the shares. That's about 2%-3% more than what you'd get from an outright sale.
Depending on the duration for which you're willing to write an option, the extra amount you get from the covered call strategy can be substantial. Here are some examples:
|
Stock |
Recent Stock Price |
Call Option |
Option Price |
Extra Profit With Covered Call |
|---|---|---|---|---|
|
Google |
362.00 |
June 340 |
42.80 |
5.7% |
|
Bank of America |
7.06 |
November 6 |
2.85 |
25.4% |
|
Petroleo Brasileiro |
34.01 |
May 31 |
4.51 |
4.4% |
|
Target |
37.60 |
October 31 |
9.42 |
7.5% |
|
Research In Motion |
61.91 |
June 50 |
14.70 |
4.5% |
|
SPDR Trust |
82.53 |
December 75 |
14.04 |
7.9% |
Source: CBOE. Prices as of market close on April 8.
Another benefit of this strategy is that you get all the benefits of owning shares until the option gets exercised. For instance, if your shares pay dividends, you get the payments.
The downside
Of course, there's a trade-off with the covered call strategy. If the stock price falls below the strike price you choose, your option won't get exercised, and you'll be stuck with the shares. But you'll also pocket the entire option premium -- which, as you can see from the examples above, could easily give you between 10% and 40%, or even more, of the current stock price. Moreover, if you would have bought the shares back after a correction anyway -- as many long-term investors would do after taking profits -- then the covered call strategy essentially compensates you for taking that risk.
If you're truly a long-term investor, you're probably not thinking about taking profits anyway. But if you can't resist locking in some of your gains, think about whether you'd like the extra profit that the covered call strategy offers. You may find that it's the next best thing to free money.
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