Magazine article Modern Trader

Options Strategy

Magazine article Modern Trader

Options Strategy

Article excerpt

Question: How can you take profit on a winning trade yet maintain upside potential?

Answer: Hedge upside risk with calls.

Everybody knows that puts offer excellent protection against a downside move. Well, calls offer the same excellent protection against a move to the upside. And, no, I'm not talking about using calls to hedge against a short stock or futures position. We'll leave that to the hedge funds and market makers. I'm talking about using calls to get out of a long position and still stay in the game.

Let me explain: We'll take two scenarios. 1) You bought the stock or future at a lower price and you want to take some profit but are worried about missing a further move upwards, and 2) You bought the underlying asset at a higher price and want to cut your losses but are afraid of getting out at the bottom.

We will provide two examples: One using the stock market as a whole and one using a particular stock. Two caveats before I begin. First, I am assuming a frictionless market. By that I mean that I take no account of commission rates, the bid/offer spread, or any tax consequences. Second, the following examples are price specific as of Dec. 9 at 1:00 CST, and obviously cannot be replicated exactly. The purpose of this article is to demonstrate another way of looking at and using calls.

Let's say that you have owned for some time a broad range of stocks roughly mimicking the S&P 500. We'll use the ETF that matches the S&P 500, ticker symbol SPY (see chart below).

As of this writing SPY is trading at 205.94, not all that far from its 52-week high of208.47. And you want to lock in some profit before year end while at the same time keeping upward potential.

So, you sell your stocks and at the same time you buy the SPY January 2015 call with a strike price of 210. That option is offered at 1.10, or $110 per option.

If the market powers north above 210, your call kicks in and you only miss roughly four points, or just less than 2% of further upside. …

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