How to Use Options To Protect Your Profits – And Play for More

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 pur chased 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:

• By selling 500 shares of CTL at $46.40, you free up $23,200 ($46.40 x 500 = $23,200) in cash that you can use for other purposes (a benefit you wouldn't get with the purchase of a protective put).
• You capture the $6,450 in profit you currently have, ensuring you'll never give it back - no matter what the market or stock price does.
• With the February $46.00 calls carrying a premium of $1.40 (as they did on Dec. 28), you'd pay $700 ($1.40 x 100 x 5 = $700) of your profit to buy them and thus maintain your long position by controlling 500 shares of CTL stock.
• If the market does correct and CenturyLink stock falls back below $46.00 a share, you lose the $700 you paid for the calls - but that's all. You can't lose more, no matter what happens. (Note: If you dislike the notion of losing the $700 in call premiums should the stock pull back, simply think of it as equivalent to putting in a stop-loss order on CTL at a price of $45.00 ! per shar e. If you simply held the stock with that stop - a very tight one by usual standards - you'd lose the same $700 from current prices if it were triggered.)

• If the market doesn't correct, you begin adding to your already locked-in profits as soon as CTL stock moves higher. Because the $46.00 calls are already in the money, the premium will increase steadily - though initially not on a cent-for-cent basis - as the stock price rises. And, if you hold the calls until the expiration date - Feb. 18, 2011 in this instance - you'll capture additional dollar-for-dollar profits at any CTL stock price above $47.40 (the $46.00 striking price plus the $1.40 premium paid).
• Because CTL will report its fourth-quarter results before the options expire, you'll have full opportunity to capture any bounce in the stock price as a result of a positive surprise. But again, you can't lose the gains you already have should earnings disappoint.
• Should CTL stock trade relatively flat in January and early February, staying above $46.00 a share, you can re-examine the prospects for the company and, if you like them, exercise the call options. That would let you repurchase the actual stock in time to collect the next 72.5-cent quarterly dividend, adding another $362.50 to your gains on the 500 shares.
• Since it will most likely be the first week of January 2011 before you can execute this trade, you won't have to pay taxes on the stock profits you take for up to 15 months, giving you plenty of time to offset them.

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.