Most investors are happy with unrealized gains, but there’s always a risk of loss until they sell. Fortunately, there are a couple of options strategies that you can use to protect gains by locking in profits without immediately selling your stock. The key is finding the strategy that provides the right level of protection, upside potential, and income to match your investment goals.
Let’s take a look at how put options can help you lock in profits.
Protecting Profits with Puts
Buying put options give you the right to sell a stock at a set price until the contract expires. As a result, you can purchase put options covering the number of shares you own to lock in profits. If the stock declines, you can still sell the stock at the put option’s strike price. Conversely, if the stock rises, you can continue to benefit from the upside.
Protective put option diagram. Source: TheOptionsGuide
For example, suppose that you purchase 100 shares of a stock at $10 per share for a total of $1,000. Over the next few months, the stock rises to $15 per share, and you have $500 in unrealized gains. You think it will reach $20 per share, but you’re worried about a drop in the broader market that could temporarily depress the stock price.
You decide to purchase a put option contract with a $12.50 strike price for $0.50 per contract. As a result, you effectively lock in $2.00 per share in profit ($12.50 – $10.00 – $0.50) at a total cost of $50 ($0.50 x 100). If the stock rises, you lose out on the $50, but if the stock drops, you will always be able to sell the stock for $12.50 per share.
Selling vs. Protective Puts
Protective puts are an excellent way to lock in profits, but the protection doesn’t come for free—you must pay an option premium. If the stock rises, any gains you realize are offset by the put option’s premium, reducing your overall returns. As a result, you might wonder why you shouldn’t just sell the stock and repurchase it later.
There are several instances where protective puts may be preferable:
- You don’t want to risk timing the market by selling the stock too early or buying back too soon.
- You are affiliated with the company and own restricted stock or would prefer not to sell it.
- You don’t want to realize the capital gain. Or, you want to ensure it’s a long-term capital gain and not a short-term capital gain.
- You don’t want to incur the trading costs (commissions) of selling and repurchasing the shares.
The challenge with put options is that your predictions must be accurate within a specific timeframe. In other words, protective puts only lock in your profits for a specified period (expiration). You lose that protection when the put option expires. On the other hand, selling stock enables you to lock in profits permanently until you decide to repurchase the stock.
Lowering Your Cost with Calls
Covered call options are another way to lock in profits. When you write a call option against a long stock position, you generate premium income that you can use to lower your cost basis. If the stock declines, the premium payments can help offset those losses without selling the stock. However, your upside is limited to the call option’s strike price.
Covered call option diagram. Source: TheOptionsGuide
For example, suppose that you’re in the same situation discussed earlier with a stock that rose from $10.00 to $15.00. Rather than buying a put option, you might decide to sell a call option at $17.00 producing an income of $0.50 per share. The $50 that you receive in premium income can help offset a decline and lower your cost basis to $9.50 per share.
Protective puts are ideal for maximizing the stock’s upside potential and limiting losses, but covered calls can generate an income over time. For instance, you can write new covered call options every month to continuously lower your cost basis rather than having to buy a new protective put every month to lock in gains.
Tips for Managing Covered Calls
Covered call options are great as long as the option holder doesn’t exercise them. However, if the stock is near or above the option’s strike price, the option is at risk, and you should take action if you want to keep the stock. Fortunately, there are several things that you can do to avoid selling the stock and incurring a potentially significant loss.
The most common responses include:
- Closing out. You can buy back the call option at the market rate. This will cost you money and may be more than the premium you originally received.
- Unwind. You can buy back the covered call option and sell the stock to unwind the position entirely.
- Roll out. You can buy back the covered call and simultaneously sell the same strike for a later month.
- Roll out and up. You can buy back the covered call and simultaneously sell a higher strike covered call for a later month.
- Roll out and down. You can buy back the covered call and simultaneously sell a lower strike covered call for a later month.
The best option depends on the situation. If you believe that a stock’s gains will reverse, you may decide to roll out the option to give yourself a little more time. If you’re losing confidence in the stock, you may decide to unwind the position entirely. If you want to preserve the income, you might roll out and down to maximize the premium.
The Bottom Line
Protective puts make it easy to lock in profits, but you should carefully consider the pros and cons before using the strategy. You can also use covered calls to lower your cost basis over time and lock in profits while simultaneously generating a cash income. The right decision depends on the situation, your risk tolerance, and your investment goals.
The Snider Investment Method uses covered calls to generate a consistent income in retirement.