How to lock in your stock trading profit using options

by Tom Nunamaker on October 28, 2009

Most stock traders use stop-loss orders to lock in profits on their open trades. This normally works well until the security gaps through your stop. You only have protection IF the security trades through your stop-loss order and doesn’t gap past it. The protection is not guaranteed using stop-loss orders. How can you guarantee protection? Using options of course!

Using options to lock in your profits avoids the problem of the security gap moves that bypass your stop. How does this work? The option guarantees you can close your position at a specific price no matter what the underlying security is trading at. For example:

Suppose you buy IBM stock for $100 per share. The stock rises to $128 per share and you are concerned it will fall in price but you would like to keep the possibility of making more profit open. You have several ways to achieve this using option:

Method 1 – Buy a put

Suppose a six month, $135 put is selling for $13. Purchasing this put will guarantee that you can sell your stock at $135 per share at anytime in the next six months. It costs you $13 per share for this insurance. Since each option contract is for 100 shares of stock, the price of the put would be $1300. Since you can sell your stock for $135/share, your effective guaranteed price is $135 – $13 or $122 per share. You are risking $6 of your current profit to implement this strategy. Any profit you make if the stock continues to rise, will be reduce by $6. Here’s how it looks:

Stock and Stock+Put

Stock and Stock+Put

Notice that the Stock + Put position can’t lose money now! The cost, or margin, of owning this position is the stock price plus the put price. The capital required is higher than just owning the stock.
Is there another way to achieve this? Yes!

Method 2 – Sell your stock and buy a call

In this example, we notice the six month $135 call is priced at $6. We can sell the stock, and take the profit of $28 per share, and spend $6 of it to purchase a call. The risk chart looks like this:

Long Call

Long Call

Wait a minute. This looks like the stock and put combination doesn’t it? It sure does. There is a relationship between puts and calls called put call parity. The two prices are mathematically linked together. Because of this relationship, there are “synthetic” positions you can create by substituting stock, calls and puts in the right way. This is one synthetic relationship… stock and long put = long call.

This is a simplified version of the put-call parity relationship. I’ll write about that more in the future. But this is why the call looks like the stock and put position. They are essentially the same. If they weren’t and one had an advantage over the other one, arbitragers would quickly descend on the position and trade it (or “arb it”) back to parity where neither position has a trading edge.

Which method should I use?

That depends. Do you want to keep your stock? Do you want to reduce the capital being used? To compare apples to apples, if you use method 2, your cash generated from selling your stock should be placed in a risk free, interest bearing vehicle. Here’s a quick summary comparing the two methods:

Method 1 – Buy a put

• More capital required
• You don’t have to sell your stock. If the stock continues to rise, you can close your option for a loss but the increased stock price should compensate for that loss
• You receive dividends the stock pays

Method 2 – Sell your stock and buy a call

• Less capital required
• Your trade is simplified as you only have to monitor one security instead of two.
• You don’ t receive dividends
• You collect interest on the idle cash

The temptation is to use Method 2 and use the cash generated by the stock sale to trade something else. While this is possible, you are increasing your risk exposure and leverage by doing this. So be VERY careful if you trade that idle cash!

You can see that in either method, stock price gaps on the way down just do not matter. If the stock price went to $0 tomorrow, your positions have limited risk in either event. Without using options, your stock position would be wiped out. This is how options can be used as insurance policies to protect you.

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{ 3 comments… read them below or add one }

Sheridanoptions October 28, 2009 at 9:15 am

A new article “How to lock in your stock trading profit using options” is posted on our blog at http://bit.ly/3eUfBF

This comment was originally posted on Twitter

Larry Richards October 29, 2009 at 8:22 am

Thanks for the great article Tom. This might be a little off topic, but I thought of one more reason you might prefer Method 1 – ease of execution. Particularly if you’re looking to protect a basket of stocks rather than all of a single company, it’s a lot quicker and simpler to just buy a few puts on an index, e.g. SPY or SPX, as opposed to using Method 2 for each individual stock. I guess you have to be pretty confident in having a high correlation between your basket and the chosen index, though.

Tom Nunamaker October 29, 2009 at 3:37 pm

Thanks Larry,

I agree that using indexes to protect a larger basket of stocks makes a lot of sense. The article was really talking about a single position. Just to get traders thinking about ways to protect themselves. This isn’t a bad time to think about how to use options to protect gains made this year. It’s always good to have alternatives in your hip pocket!

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