When most investors hear the phrase "hedging," they typically take an exasperated breath, roll their eyes, and think to themselves that it's far too complicated – but it's actually not.
Last week I covered a simple but very effective method to buy highly speculative biotech stocks ahead of critical announcements – and guarantee a safe exit price – even if the stock crashes as a result of poor trials results.
This week I want to expand on the same idea – but instead of focusing on establishing a new position, I want to focus on protecting hard-earned gains on big winners – specifically small-cap stocks ahead of earnings.
Small caps were on a tear in 2013, with the iShares Russell 2000 Index (ETF) (NYSE Arca: IWM) returning 36.81%, compared to SPDR S&P 500 ETF Trust (NYSE Arca: SPY), which returned 29.69% over the same time period.
That's great for investors targeting small caps like we do in Small-Cap Rocket Alert. Already in 2014 we've created three free trades after selling half our positions at 100% plus gains.
If you find yourself in the same enviable position, the next thing you'll want to consider is implementing a strategy to keep those gains from turning into losses – especially as the company comes up on such a potentially disruptive event as earnings…
Get the Share Price You Really Want…
When markets are running at new highs, like they are right now, it doesn't take much to get traders running for the exits to capture profits. This is especially true when it comes to small-cap stocks, which are typically considerably more volatile than their large-cap counterparts.
The same small-cap stock that has run up more than 100% in a few short months can see its share price cut by 20% to 30% in a single day if it misses, even modestly, when the company reports earnings.
Most investors will simply use a "stop" order as a means of protecting themselves from these kinds of events – but that type of order won't do you much good if the stock trades, in the afterhours, far below your stop.
In that case, the market will open and your shares will be sold at market, which could be well below the desired price you intended to sell your shares.
And seriously cut into your gains…
A much better way to protect yourself is to simply buy a near-dated put option with a strike price at which you would feel comfortable selling your shares. This strategy ensures you exit the position at the price you want (over the length of the contract) no matter what happens to the share's price.
Here's the best thing: If you're looking to hedge a position (using a put option) that has already run up considerably, the put options could actually be really cheap because most traders have lost sight of risk, and instead, are focusing solely on additional upside. Â
…With This Simple Technique
Let's take a quick look at how this kind of trade might look…
Let say you purchased XYZ in December 2013 at $3.00 and now it's trading at $6.50, which represents a hefty 116% gain in less than three months. And, let's also assume the company is going to report earnings in the next few days.
About the Author
Sid is the investment community's best-kept secret. Since 2009, he has served behind the scenes at Money Map Press as Director of Research, analyzing hundreds of securities and profit opportunities for subscribers. He's an expert in the identification of specific market catalysts with "alpha" potential in a wide variety of industries, but especially the small-cap sector. From his years of research and training, Sid has an extreme attention to detail and a passion for identifying unique opportunities the market doesn't yet understand. He brings those recommendations to members of his Small-Cap Rocket Alert.
Sid is also an accomplished drummer and music producer. He lives in Denver.