When to Sell: It’s No Longer
the Hardest Decision
By Bill Johnson
It’s often said the hardest decision an investor must make is when to sell. Sell too soon, and you miss out on a potentially skyrocketing stock price. Sell too late, and you could sink with the ship. Buying is easy; selling is difficult. However, options can make the difficult challenge of selling a thing of the past. It’s done with a strategy called a stock swap.
Here’s how it works. Let’s say you purchased 500 shares of stock at $45 and it’s now trading for $56. You think the stock will continue higher, but at the same time, don’t want to see your gains turn to losses. The most common approach investors take when faced with this dilemma is to sell the stock and look for another opportunity.
The problem with this approach is that the new stock you pick is equally likely end up heading south as the one you currently own. If you always try to sell your stock at the top and look for another to buy at the bottom, you’ll end up generating a ton of commissions and probably be worse off than if you had just stuck with the original company in the first place. Trends last longer than people expect, and the better approach is to hedge your position and get your money back – plus a return – and maintain the position. That’s what hedging is all about.
Protecting Profits with Stock Swaps
The underlying stock is $56 and the following option quotes are available:
To enter the stock swap, sell your shares of stock and simultaneously replace them with a share-equivalent number of call options. In this example, you may sell 500 shares of stock at $56 and simultaneously buy five $55 calls for $3.38. The net credit is $52.62 per share:
Sell 500 shares at $56
Buy 5 $55 calls at $3.38
Net credit = $52.62
The effect of this hedge is that you’ve swapped your shares for a call option – and collected a net credit of $52.62, or $26,310 for 500 shares, which is sitting safely in cash. Your original purchase price was $45, or $22,500 for the 500 shares. The swap guarantees a return of $26,310 – $22,500, or $3,810. That’s a 17% guaranteed return on your money – but still leaves you with unlimited upside potential. However, you’re still effectively long 500 shares of stock if it should continue to rally. If it crashes, the worst that can happen is you made $3,810.
The strike you choose is a matter of preference. If you buy a lower strike call, such as the $45 or $50, the good news is that it’ll behave more like the stock and move closer to dollar for dollar with the underlying stock. The bad news is that lower strike calls won’t recoup as much of your original principal since lower strike calls are more expensive. Because the goal of the stock swap is the recoup your principal, or at least a good portion of it, most investors use at-the-money or slightly out-of-the-money call options.
Stock swaps prevent you from trying to time the market. When you sold the stock for $56, was that the very top? Probably not. At the same time, it’s not easy to hold a position when substantial profits start to build. The stock swap provides a solution to both problems. The following profit and loss diagram shows the effect of our stock swap hedge:
You can see that the original stock position (red line) assumes risk all the way down to a stock price of zero. The stock swap (blue line) not only removes all of that risk, but it also guarantees a minimum of $7.62 per share, or $3,810 in profits for the 500 shares.
The tradeoff is that the stock swap will not be as profitable as the shares alone if the stock should rise. The reason is you paid $3.38 for the call options, which is an unnecessary expense if the stock continues higher. But since we don’t know what will happen to the stock in the future, the hedged tradeoff provides a very comfortable and reasonable strategy for investors. You’re simply sacrificing the $3.38 time premium in exchange for a guaranteed $3,810 profit – but still have the potential to make more money if the stock continues to rise. Once you’re in a guaranteed position, the decision to hold the position is much easier. The difficult decision of when to sell is eliminated and you can now hold on for serious profits. Options give all investors – including stock owners – better choices. The stock swap ensures you’ll never have to worry about when to sell.
Good Investing!
Bill Johnson, Steve Bigalow
and The Candlestick Forum Team
P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.
