The Smart Alternative to Selling These Winners

Financial markets are behaving strangely, and it has a lot of investors completely freaked out.

By now, you've gotten used to the news of the dollar's steady, consistent drop day after day. Gold has hit record highs regularly for weeks now and shows no signs of stopping. The stock market has benefited not just from the rise in commodity-related stocks but from general optimism among investors of all sorts. Even bonds, which you might expect would suffer in such a pro-stock environment, have posted surprising gains and drawn a lot of investor interest.

It's kind of like when your kids don't fight, your in-laws are nice to you, and your dog stops barking through the night. You just know something's about to happen -- and it's probably going to be something you don't like.

2 ways to protect yourself
So if you're convinced that a return to the Armageddon-like days of last fall are inevitable, what can you do to lock in the amazing gains you've seen over the past eight months?

The most obvious way is simply to sell everything. Hit the emergency exit button on your brokerage account, hock the gold coins and silver bars you just bought on eBay, and go deposit your fortune among enough different banks to take advantage of the $250,000 FDIC limit on your entire stash. Then sit and wait -- collecting a pittance in interest all the while -- for everything to go bad.

That's fine if you have perfect timing. But what happens if the things you just sold continue to rise in value? What will you do next? You're left with some unappetizing choices:

  • Buy back what you sold at higher prices. Not only does that cost you money, but you're left with exactly the same risk you had when you started.
  • Keep waiting. You can join everyone who said the rally would end two months ago, four months ago, and six months ago. Bring a good book, because you could be waiting an awfully long time.

Even worse, selling everything immediately triggers a capital-gains tax on all your profits. If you just picked up shares a few months ago, you'll have to pay your full ordinary tax rate on those gains -- a bite you really don't want to pay right now.

If you don't want to face that dilemma but want to protect yourself against even the slightest loss, there's another thing you can consider. Rather than dumping everything and hoping you have good timing, you can turn to options for the insurance you're looking for.

Running the option
Buying put options is the simplest way to use the options market to protect your portfolio. By specifying a particular length of time and the minimum price you're willing to accept for your shares, you can find the right option to match up with your current holdings. If your stocks drop in price, you exercise your option and collect a higher amount. If they keep rising, you're not obligated to sell and instead get to keep the profit for yourself.

As you'd expect, put options come at a cost. And even with the market in a firmly established uptrend that makes puts less popular than when stocks are plummeting, that cost is still pretty high. Here are some examples of put options that give you two to six months of protection, using stocks that have posted some big gains in recent months.

Stock

Stock Price

Put Option

Option Price

Wells Fargo (NYSE: WFC  )

$28.21

April 2010 $28

$3.40

Ford Motor (NYSE: F  )

$8.71

March 2010 $9

$1.12

Apple (Nasdaq: AAPL  )

$206.63

April 2010 $210

$20.50

Green Mountain Coffee Roasters (Nasdaq: GMCR  )

$69.96

March 2010 $70

$7.78

Wynn Resorts (Nasdaq: WYNN  )

$68.51

January 2010 $65

$4.40

Coca-Cola (NYSE: KO  )

$56.74

May 2010 $57.50

$4.09

Baidu (Nasdaq: BIDU  )

$438.32

March 2010 $440

$46.07

Source: Chicago Board Options Exchange. Closing prices as of Nov. 16.

You can see that short-term protection from a market reversal certainly isn't free. With some of these options costing 10% or more of the stock price, buying put options is not something you want to do constantly -- but at appropriate times, doing so might be worth the price.

Have your cake and eat it, too
So if you're thinking about getting out before the last best asset bubble finally bursts, consider your other option: options. If you're not sure stocks won't rise even further, then options may give you a better solution to your risk problems.

Foolish options expert Jeff Fischer was recently featured in Barron's. See what he had to say about using options to improve your investing results.

Fool contributor Dan Caplinger has nice in-laws, but his daughter's cranky enough right now to reassure him that everything's OK. He doesn't own shares of the companies mentioned in this article. Baidu and Green Mountain Coffee Roasters are Motley Fool Rule Breakers picks. Apple is a Motley Fool Stock Advisor pick. Coca-Cola is a Motley Fool Inside Value selection and a Motley Fool Income Investor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy won't leave you in the dumps.


Read/Post Comments (6) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 17, 2009, at 6:13 PM, Maui808Gal wrote:

    I have not done the "Option" thing before. How do I go about taking advantage of this with out making a horrible mistake and REALLY losing? What are the pitfalls? There must be...or everyone would be doing this all the time!

    Can I buy put options on any stock or are there restrictions? Example, I own 225 shares of a Ford Preferred stock (F-S). I'd like to hold on to them, as the divs have been suspended and I would like to collect once they're reinstated. On the other hand, I dont want to lose the 155% gain I've experienced.

    Can some one direct me to some sound information/guidance on how to do the "option" thing?

    Mahalo,

    Sharan =)

  • Report this Comment On November 17, 2009, at 6:59 PM, maccdw wrote:

    How about seling covered calls, with a strike price above your buy price, and above the current price? Sell them for short-term, less than 3 months out. If your stock hits, you get a profit plus a premium. If it treads, or even loses, you keep the premium and do it again.

    Buying puts means you are betting your stock sinks. If your stock gains, you wasted your premium.

    Maybe I'm missing something here...?

  • Report this Comment On November 17, 2009, at 7:16 PM, kayakmastr wrote:

    If you want to learn about options, subscribe to Motley Fool Pro. I did this year, followed their recs, and it really paid off!! Buying a PUT costs you money. You lose from the beginning and hope to recover more. The safest option is the COVERED CALL. Buy 100 shares of something you want to own anyway. Sell a CALL, you now are ahead. Someone paid you $$$ for you to sell your shares to them in the future at a higher price than you paid for them. Isn't that what you want to do anyway? And someone pays you to do it! If the stock takes off and it looks like you agreed to sell at too low of a price, you just buy a second 100 shares to sell at an even higher price. I use 100 shares because options contracts are done in units of 100 shares. You can't lose more than you would have without the options because you wanted to own the shares anyway, selling the covered call is just an add on that brings in $$$. Selling the call wins, the stock you picked may be the loser.

  • Report this Comment On November 17, 2009, at 8:51 PM, TMFGalagan wrote:

    kahakaiBum -

    Not all stocks offer options; for instance, regular Ford shares have options but I don't believe the preferred shares do.

    This article and the other ones it refers to can get you started:

    http://www.fool.com/investing/options/options-a-foolish-intr...

    best,

    dan (TMF Galagan)

  • Report this Comment On November 17, 2009, at 8:54 PM, TMFGalagan wrote:

    maccdw and kayakmastr -

    Selling a covered call is indeed another useful option strategy and can work well if the stock price stays stable or climbs.

    But it doesn't protect you from a drop in the stock, except to the extent that you receive a premium when you write the covered call. If shares tank, you'll be slightly ahead of where you would've been without the covered call, but you'll still usually have a substantial loss.

    Buying a put is indeed expensive, as I point out. But it's one choice to consider if you don't want to give up potential gains by selling the stock outright.

    best,

    dan (TMF Galagan)

  • Report this Comment On November 17, 2009, at 8:56 PM, TMFGalagan wrote:

    maccdw and kayakmastr -

    Covered calls are another useful options strategy. They work well if the stock holds its value or rises.

    But they don't provide protection from falling shares. You'll get a small premium for selling the call, but otherwise, you'll be exposed to the full extent of the stock's loss.

    Buying puts is indeed expensive, as I point out. But it's something someone might consider doing if they don't want to give up potential gains by selling the stock outright.

    best,

    dan (TMF Galagan)

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