Locking In Profits With Options: The Final Chapter

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

With U.S. equity markets at all-time highs, many people are thinking about how to protect profits on a stock, or a portfolio, against the inevitable day when the next bear market begins. I have discussed various ways to do this using options, in the articles that you can read here and here. Today’s article will wrap up this subject for now. Several of the methods we explored earlier involved continuing to hold the stocks. The one we’ll look at today involves selling the stocks, and replacing them with a combination of interest-bearing deposits and call options.

Let’s say we have a portfolio of stocks worth one million dollars, and we are concerned that the market could drop substantially from here. Despite our concern, we also know that the market could continue to rise, and so we are reluctant to sell out and then be left behind completely.

I’ve left this method for last, because the current environment is not the most favorable one for it. I’ll explain why below.

In its simplest form here’s what it would involve:

  • Sell the stocks.
  • Calculate the amount of money that could be earned in the next year on a risk-free interest-bearing account, on the cash generated from the stock sale.
  • Deposit the amount of cash in that interest-bearing account that will grow back to the full portfolio value in a year, at the risk-free rate now available.
  • Use the balance of the cash to buy call options.
  • In a year, the interest-bearing account alone will once again be equal to the full current value of the portfolio.
  • If stocks have gone down, the call options will be worthless, and the net profit/loss will be zero. There will be no net loss in the portfolio, no matter how low stock prices have dropped.
  • If stock prices have gone up in a year, the call options will show a profit, which is unlimited. The value of the call options at that time, if any, will be the net return on the portfolio.
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    Author: Travis Esquivel

    Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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