Are you ready to lock in some profits with the protective put?
Do you happen to own Tesla (Nasdaq: TSLA), Netflix (Nasdaq: NFLX), Facebook (Nasdaq: FB), Twitter (NYSE: TWTR), Veeva Systems (NYSE: VEEV) or 3D Systems (NYSE: DDD)? Recently, well-known investment advisor and fund manager Marc Faber, otherwise known as Dr. Doom, recommended shorting a basket of these momentum stocks because “they are all overpriced,” he said.
The same could be said for many other high-flyer stocks over the past year.
While I’m not necessarily in agreement with the perennial permabear, I do believe that the market is due for a pullback. Just look at the facts. After 13 years of the S&P 500 basically going nowhere, the major market benchmark finally pushed through the decade-plus trading range in 2013 to a historic 30% higher – the best return in over 15 years.
Remember, the market has spent the last five years climbing out of the enormous hole created by the market collapse in 2008. And after recently passing the five-year anniversary of the latest bull market run, I can’t help but remind investors that the market is over 135% higher since the low was established in early 2009.
So, again, a pullback should not be unexpected…and I want to show you how to keep your profits rather than sell many of the stocks you might wish to own for the long term.
Let’s say you purchased 3D Systems at the start of 2013 for $38.50.
As it stands, you’ve made over 50% in the stock in just over a year…a great return by most standards. But, like any normal investor, professional or otherwise, you missed the top at the beginning of 2014. Shame on you…how could you?
But, as you can see from the chart above, now might not be the best time to liquidate. The longer-term RSI (14) has hit an oversold extreme, which typically indicates a push higher, or at least a reprieve from the selling is on the horizon. We’ve already seen 40% decline in the last three months so it makes perfect sense that a reprieve is right around the corner.
More importantly, you bought DDD because you thought the company was going to be a big winner over the long term and you wanted to buy and hold. You are willing to take your lumps, but you want to do the prudent thing and keep your 50% return after the three-month decline.
So, how do you combat this type of situation?
There are two ways: collars and protective puts. Both are wonderful ways to protect profits, but since I’ve gone over collar strategies in past articles I want to introduce a simpler, more straightforward strategy…the protective put.
The Protective Put: Long-Term Protection for Your Portfolio Profits
Let’s say you own 100 shares of 3D Systems and it is currently trading $20 above your original purchase price of $38.50. You want to continue holding the position, yet you are concerned that the bull market is about to burst.
What is the best way to protect your gains over the long term?
I have discussed the benefits of the collar option strategy in the past (one of my favorite stock and portfolio hedging strategies) as a form of short- to intermediate-term protection, but in this case, for longer-term protection I would prefer to buy a protective LEAPS put.
Long-term Equity AnticiPation Securities (LEAPS) are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years.
Example: DDD is trading at $58.50. You are long 100 shares at $38.50 and want to hold DDD for the long term. You’ve already lost $35 per share and do not want to risk losing the remaining $20 increase in share value, or $2000, and you are perfectly fine paying the cost of insurance if it means that you will be able to keep a portion of your current gains.
Outlook: Again, you are bullish on DDD over the very long term but nervous about unseen events over the next 3-18 months.
Strategy: LEAPS Protective Put – Buy 1 DDD January 2015 55 put for $5.00 or $500 with the stock trading at $58.50.
Stock Change DDD Long 55 Put Stock P/(L) Option Cost Net P/(L)
+19.7% $70 $0.00 $1,150 ($500) $650
+10.5% $65 $0.00 $650 ($500) $150
0.0% $60 $0.00 $150 ($500) ($350)
-6.0% $55 $0.00 ($350) ($500) ($850)
-14.5% $50 $500 ($850) ($500) ($850)
-23.1% $45 $1000 ($1150) ($500) ($850)
As you can see in the chart above, the $500 cost of the DDD LEAPS options insures your stock position to a maximum loss of $1,150 with unlimited upside potential after the break-even point of DDD at $63.50, or 7.8%.
The maximum loss is based on the cost of the LEAPS protective put ($500) plus the out-of-the-money amount ($350) at the time of the established position. The most you can lose on DDD is -6.0%, or $850, no matter how far the stock drops.
The stock could drop back to $25 or below and your max loss would still be ($850).
So, if you are fearful of a sharp push lower in coming months and you want to protect some of your hard-earned long-term profits, think about using a LEAPS protective put. It limits your downside while leaving the upside potential of the stock intact.
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