I was going to post this yesterday but I got distracted and didn’t get around to it.

A lot of people have problems calling tops, and they have a problem with deciding when to take profits.  A stock might move 20%, but they could still be very bullish on it, however they would understand that a pullback should occur at some point. Not protecting profits is risky and could be very dangerous, but not holding on to a stock that could move much higher would be a sin. So you’re stuck between a rock and a hard place… Or are you?

There’s a way that you can both take profits, and still maintain the same upside control over a stocks move.  Lets say you bought FSLR at about $200… Although it has plenty of room to run, you could be concerned about a pullbback.  Most people just take profits, and risk missing out on some of the upside move, but not all.

I prefer to take all my profits off the table, while maintaining my same upward leverage. Lets say you bought 200 shares at $200, or $40000 worth. Now you can sell your 200 shares and replace them with 2 in the money calls (or at or out of the money if you prefer).

A $200 April call is 37.75, but remember an option contract is for $100 shares, so you can pay $3,775 for the rights to control 100 calls, or $7550.  The intrinsic value at the time of writing this would be [[FSLR]] 232.5-200 or $32.5, which is what it would be worth if expiration was today.  But that means $5.25 is time value, which will decay the longer you wait.   If you think the stock will not make a $5.25 move before expiration, you can just sell now. But what if you think FSLR will go up for a longer period of time, or you want to minimize the time decay? Well you can buy calls that expire in May or June.  But EVEN IF you bought JAN 09 In the money calls, you would still pay less than your original costs, thus, cashing out some profits.  $78 or 7800 per contract, or $15600 would be the cost for 2… Since you bought at $200, and the stock is now worth $232.5, you get to cash out $46500, and only put in $15600… a total of $30,900 comes out into your pocket, and your upside potential for gain is basically the same minus the timevalue you lose. It’s often very possible to actually get ALL of your money off the table, although sometimes it requires at the money or out of the money calls to do so.

I prefer to swap and get close all of my own money out, and  sometimes when I’m really bullish, even add another call or two.  So maybe those APR $200 calls, for $3,775 per contract I buy 3 of them, rather than 2, adding an extra 100 shares worth of upside, minus the time value I lose.  That’s $11325 out of my pocket, and $46500 in.  Since I started the investment with a $40,000, I might still have an extra $5000 of my original investment in the stock, so all my money isn’t off the table, but enough profit has been taken, that I would have to do something completely idiotic and lose time value as well as intrinsic value, and the stock would have to somehow expire out of the money for me to really lose that $5000, and I could very well ride it up to $240, and gain more. Since I’ll be watching the stock, and cutting “losses” short, and not letting it get too close to expiration, it’s very unlikely that I will ever in worst case scenario not get my money out and then some, and my upside is still very good.

But you don’t have to do this from stocks to options, you can also do this from an option on a stock that has gained in value, for one at the money and take some profits out as well, you might buy an at the money option to start with, and then after the stock goes from $215 to $240, you take your $25 per share profit which is really $2,500 per contract, and you buy an at the money option at $240 for maybe $15, and you not only have all of your money out, but you also have some of the profits out as well.

There’s basically 2-4 strategies I use with options, and this is one of them.  It goes along with my pro “gambling” money management strategy or “playing with the house’s money”.

Don’t be fooled into thinking that because there is risk that is neccesarily risky.  It is only as risky as your stock, and amount of capital that goes into that stock, and the money management you use.  You can still use stops to define your risk, and make sure the upside outweighs the risk, and use strategies like this to limit the risk when possible.

There is risk involved when you drive a car, but you don’t have to speed and drive with your knees while you check your hair and while you’ve had too much to drink, and while some girl services you.  

 You can drive a car, without being a risky driver, and you can take the steps to manage risk and preserve capital, look for the best risk/reward, while preserving the capital and managing the risks, and use techniques like this and still “gamble” on the bigger moving stocks, without being a risky investor.

Ask any dotcommer who looked at dotcom stocks that were “undervalued” in comparrison to the rest of them in the dotcom days if they could have bennefitted from a mindset that allowed them to understand the risks and manage them well as if a pro gambler would. 

No doubt, everyone who lost a significant amount of money in that time would have done MUCH better if they still invested in those firecracker stocks, but protected their capital, and played with the house’s money early and often., and they certainly would have done well if they bought an occasional straddle, and found an occasional short to pair it with.

Perhaps the best way is through cautious leverage the way Buffett uses the value of Birkshire and his investors capital and Charles Munger’s and his early investors capital to invest in undervalued stocks with the market cap smaller than the EBIDAS, and the cashflow and earnings greater than the price, and many things like that. 

But even though Buffett in the late 90s till early 2000’s fared much better than over 95%,there were still gamblers like Dan Zanger who went from 11,000 to 46 million, and still managed to hold onto half of it.  I certainly would never reccomend going on margin like Dan Zanger does, but without margin, he still would have over $20 million, and then been able to hang onto more than half because there would be no margin call to worry about.

Even with his tight stops, and timely investments where he’s not even in the market for the majority of the year for most years, and his tendancy to pick winners a large percentage of the time, his appetite for risk is still too much, even for me, but he still understood the risks and managed the risk well, and follows his rules. 

Some people play to win.  Maybe if I was ever given a terminal illness and it was my dream to set the record for biggest gains I might set aside an 11,000 account to trade like him, but other than that,I can be very content by finding stocks that have big upside potential, that perhaps traditionally might cary a lot of risk, but trade them in such a way where it’s minimized.  

Anyways, e3ven if you’re investing for the longhaul and finding stocks that you can own for awhile, you can still use swapping to your advantage.  Simply buy LEAPS instead when you want to make your swap.

If you had bought Buffet’s POSCO [[pkx]], you would most definately be content with your gain, but perhaps you still have a very bullish future outlook, well simply swap and take our profits, maybe even all of our original investment off the table, but through leverage still control the same amount of shares through the Jan 2010 options.

I don’t care if you’re a gambler or not, or you think that it isn’t a zero sum game and that good stocks can never go wrong, or if you think there’s no risk in the stock market if you manage your money right, or if you think the stock market is always risky more so than a game of craps… All of those people would disagree with me, but that doesn’t mean that all of you can’t still make this strategy work for them.  If you’re conservative, that’s great, buy a conservative stock, and take your profits early, and put your original cash into another conservative investment, or in money market, or to hedge any move in the dollar, put half of it in UDN, and the other half in a CD or money market… you’ll then be gauranteed to increase the VALUEIf you’re a crazy gambler, or in debt up to your life from some loan shark, and you are only content with a rediculous return, you can just swap your stock for all options and not have any money on the sideline and have it all in one stock.

I don’t know your situation.  Some would rather die than play it safe and/or have some reason why they absolutely need money to survive (maybe they need to pay for surgery and they’ll die without it) Well, obviously it’s worth risking it all, because by playing it safe you won’t get what you need anyways…

Others have more cash they know what to do with anyways, but have people they want to pass that money down to, and others can hardly lose anything if they want enouh to pay the rent next month.  I really don’t care about whatever your situation is, but  I can’t envision one in which you couldn’t use this strategy to benefit you… (unless you had a time machine and know the exact peak of a stock.)

So put this move in your arsenal, and save it for a rainy day.