You have a nice profit after a great entry and a steady rise. However, you want wait to sell the stock until after the trade qualifies as a long term gain. However, the stock’s earnings report date is approaching and you are apprehensive. If the report is disappointing your stock could be downgraded easily. This short article describes a trading strategy for protecting your profit and increasing it in case the stock tanks.
Let’s consider Check Point Software [CHKP]. Assume you bought 100 shares of it on July 30, 2010. That would have been a great entry because the price was $29.48 and it’s now $51.35. Your gain is close to 75%, $2187.00. For tax reasons you do not want to sell now. However, on this coming Friday, April 14, 2011 its earnings report is due before the open.
You are concerned. While it’s a great stock, what if the report is disappointing? What if the run-up prior to the reporting date has made it over evaluated? Even worse, what if as a consequence Check Point is downgraded over the weekend? A downgrade could easily result in more than a 10% price drop on Monday, the 17th. A 10% price drop would be over $500 and would take away about 25% of your profit.
At this point you should sell an Out-of-the-Money July 52.50 Call. It would convert your trade to a Covered Call and bring in $225 with the sale. This is inadequate for providing the necessary protection. Insurance, in the form of a $50 May Put will cost $137. The income from the Call will pay for this insurance. The purchase of the Put converts the Covered Call to a Collar.
As long as you keep the Collar, your profit will be limited to $2380 no matter how much Check Point rises. But, your concern doesn’t relate to giving up additional potential profit. It’s focused exclusively on a possible downgrade. But, with this Collar, your profit cannot fall below $2130.
If the earnings report is good and you feel Check Point has further to go, you can remove the Collar. This might cost $400-$500, depending on how well Check Point price responds to the report. However, the real opportunity arises if there is a downgrade.
Assume its price has fallen 10% to $46.21. The Put you bought has gained in value. At the same time, the Call you sold has dropped from $2.25 to $0.46. You can buy an additional Put, the May $45. Its cost will be about $110. Your net option expense would be near $25.
If the price stays at $45 or higher, your maximum profit would be limited to $2020. With the downgrade it’s much more likely the price will continue to fall. But, with this additional Put, your income would start accruing at a rate of $100 for each $1.00 in price drop below $45.
With this not-so-rare scenario, maybe bad news can be good news.
Let’s recap. When you hold a stock that you don’t want to sell and a situation arises that could threaten your profit, a Collar provides an inexpensive trading strategy for protection. If the threat materializes, you do not have to bail out. An additional Put allows your profit to grow further if the stock reverses.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.