Since bottoming out in early July, the stock market has turned in a brilliant performance, giving many investors Christmas stockings bulging with profits. However, it also has left a lot of investors nervous - though not the ones that know how to use options.
Will a strong January Effect extend the market advance, which has seen the Standard & Poor's 500 Index climb 22.97% from its July 2 low of 1022.58?
Or, will further downgrades of European debt, high unemployment, a dismal housing market and other negative factors finally stall the rally?
Although many analysts are offering projections, no one can say for sure - but fortunately, you don't really have to know. By adeptly using options, you can both fully protect your existing profits if the bull stumbles, and play for more if it charges ahead in the New Year.
And, thanks to a holiday-related drop in market volatility over the past couple of weeks, you can do so at a very reasonable price. To verify that, you need only look at the Chicago Board Option Exchange's (CBOE) S&P 500 Volatility Index (VIX), which closed Dec. 23 at 15.45 - its lowest level since just before the market's top last April.
Normally, when one thinks of using options to lock in profits, the strategy that comes to mind is the purchase of a protective put, which will pay off should the price of the underlying asset fall sharply. However, a better approach - given current market conditions, volatility levels, and the time of year - is an outright call option "substitution."
It's a very simple strategy: You merely sell the stock on which you have profits you want to protect and buy an equivalent number of at-the-money call options on the same stock - at the money meaning the striking prices of the options are the ones closest to the actual trading price of the underlying security.
Here's an example.
Let's say you purchased 500 shares of CenturyLink, Inc. (NYSE: CTL) last July, shortly after it bounced off its 52-week low in sync with the broader market. You paid $33.50 per share, then watched the stock ride the autumn rally higher to a close of $46.40 on Dec. 27 (collecting a couple of healthy 72.5-cent-a-share quarterly dividends along the way). You thus have a profit on the CTL stock of $12.90 per share (or $6,450 on the full position) - a profit you're worried about losing should the market correct early in the New Year.
Here's how you could use a call option substitution to protect yourself, while saving the opportunity to add more gains should the stock price continue to rise.
You would simply sell your 500 shares of CTL stock, but maintain your long bullish stance by "substituting" the purchase of five at-the-money CTL February $46.00 call options (each call option controls 100 shares of CTL stock). The key features of the play are:
This strategy will work for any long position on which you currently have profits (so long as options are traded on the stock), locking in your gains but letting you play for any continued advance.
Do be careful in choosing the expiration date of the call options you substitute, making sure they extend far enough out to benefit from the next quarterly earnings report and, if the dividend is worth considering, in ample time to qualify for that payout.
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