Saturday, December 21, 2013

How to protect profits – Selling discipline

  When entering the last stage of a bull market it is important to have the discipline to sell some of your winning holdings to build up cash for the next down turn. Stop losses are the emergency break, but how can you take part in the final market frenzy and still get out with most of your profits intact?

When markets are highest in price then the risk of a crash is highest. Thus we have to be able to take profits incrementally. You own or buy a stock position and you set a profit target. Say you own TD Bank shares which are currently trading around $98.00 per share. We had a great run since 2009, but how much farther can TD go? Another 10% or $9.50? That would be a share price of $107.50!  Ok, let’s assume it goes up gradually over the year by 10% . That would be 10%/4 = 2.5%  over the next quarter (3 months) or a share price of $100.94 by April or so.
A call option is the right to buy a share of a company (say TD) for a fixed price (strike price) over a certain period of time (say 3 months). You can buy the right to buy TD  at a certain strike price (buy a call option) or sell the right to buy TD at that strike price (write a call option). If you sell or write a call option then you assume the obligation to sell a TD share for the strike price within a certain time span (the term of the option). For taking on that obligation you get paid the option premium. The premium price is set using an auction system in the option market.

Options trade in contracts of 100. So you don’t buy/sell 1 option at a time but rather you trade in packages or contracts of 100 options. The option price is reported on a per option basis but the contract price is 100 times the option price (plus or minus commission).

Let's assume that we own 100 TD shares priced at $98.00.  We’re happy with the current profits but maybe we can hold on and get even more. So let’s take on the obligation to sell the shares at 100.94 over the next 3 months. Checking the option market, we find out that we cannot write a call option for exactly $100.94. Rather we find one with a strike price of $100.00 and that option expires on April 19, 2014. The current premium is around $1.50 per option or $150 for a contract. Also, we learned that TD’s upcoming ex-dividend dates are January 02 and April 01, 2014 so if the options expire on April 19 and if they don’t get exercised (i.e. the call option buyer demands to buy the shares from you) you also will receive 2 dividend payments totaling around $1.72 per share. 

If the call option is not exercised because TD didn’t trade above $100 then you keep the extra dividends plus the option premium. Write a new set of call options with a strike price 2.5% above  April's  prevailing market price and repeat until ‘called’. 

If the market crashes and your stop-loss emergency brake is triggered sell your shares and buy back your call options to close that position. This way you will be better off than if you held on to the stock without receiving the option premiums.

In case TD rises to $100 before April 19 then you’re likely to receive another $2 in profits ($100 – 98) plus $1.70  in dividends (if you’re lucky and the option wasn't exercise on or before April 1) plus the option premium of $1.50. In other words, in just 3 months, your $98 dollar TD share will earn you another $5.20 or 5.3% (that is 21.3% annualized) in additional profits before you were 'forced' to sell. Not too shabby!
If the call option gets exercised you have two choices: repurchase the shares in the market for the then prevailing market price and sell another 3 months contract for 2.5% above that market price and repeat the option selling game - NOT recommended. Or, better in my opinion: be happy and add the proceeds to your cash stash.  Now you have forced yourself to cash in your profits along with an attractive bonus.
When the market goes even higher and the risk of a crash escalates, you can start protecting your downside as well by using an option collar. That we’ll discuss in a later post.

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