There are certain times when it’s better to take profits just by selling, however there are some situations when it’s better to swap, so that you control the same amount of shares, but have less money invested.

As stated in the past, a swap is where you sell your current position in a stock, and you replace it with call options.

Of if you’re short, you can cover your shares, and replace it with a put option. The reason to swap is to take profits on a stock that has momentum and is moving big, but that has already yielded a big gain.

A swap can protect you from losing, while still alowing you to ride a gain.

The one obvious disadvantage of swaps is that options lose value as time goes on.  As such, you are paying a price to maintain your upside potential.

However, the advantage is, that if a stock moves big, you don’t miss out on a big gain, and you can still get your money out and put it to work elsewhere, or keep it on the side.

Of course the advantage of selling a stock is  that you don’t have to pay for time decay, and the disadvantage is that you won’t gain as much if the stock rockets higher. 

One valuable question to ask yourself is, “Does the gain I get from maintaining full upside exposure (and protection from loss) outweigh the time decay I lose”?

This question is simple enough, but answering correctly can be quite difficult.

For me personally, the swap is a valuable tool for explosive stocks that have explosive power, and have recently had a large gain.  If I’m still bullish on a stock, but want to protect myself I will swap.

I have mentioned this before in regards to swapping, but again want to refer back to William O’Neil’s rules to investing. He states that you should take profits when a stock is up about 20%.  However, he makes an exception to stocks that make those gains in under 8 weeks, saying they should be held for the entire 8 weeks. This is a good idea and the results are clear, and speak for themselves. I love buying such explosive stocks on pullbacks if/when I get the chance. It’s clear that allowing such stocks room to run without taking profits is more profitable, but in this case, I can make a strong argument for swapping. It frees up cash, and allows you to use more money elswhere, while still maintaining the upside leverage, minus the time value you pay.  If you ask me, that’s a small price to pay for stocks that occasionally sell off quickly, and in order to maintain your upside leverage. TBSI for me up over 20% is a very clear swap here.

If you’re really bullish, you can still manage to play more upside and still take profits..  Aside from your swap, you may want to reinvest some of your profits into a few speculative OTM options.  So perhaps you originally own 500 shares, you buy 5 call options, sell your 500 shares, and then you buy 2 OTM options as well.

A real world example is if you bought 500 shares of  (TBSI: 4.09 -11.85%) at $40/shr Now you find it at $52/shr  You sell 500 shares @ $52, banking $6000 on your original $20,000.  Now you buy 5 Sept calls with $50 strike price for $10 per share or $1000 per contract.  You pay $5000, and in an absolute worst case scenario, your $20,000 is back in your hands, plus you have $1000. So now, with that $1000, maybe you want to play a short term speculation that the momentum continues, so you buy 2 June $55 calls. You still have some profits, plus you have all of your money off the table, plus the stock moves to $60 quickly you’re going to bank more coin than before. You would look to sell your June $55 calls much more quickly. The reason is, the time decay is accelerating as it approaches expiration. So maybe you look for a move above $55, or if it comes down to it, you sell regardless in a couple weeks.  Time decay is nothing to sneeze at, you never want to lose 100% of the value by letting an option expire.

While playing with this method, you should leave more cash on the side than usual, since options are leveraged investments that are much more volitile.

You can definately swap in other situations, however, by keeping things simple, you won’t over complicate things.  You may want to avoid swapping if the VIX gets too high as well. I suggest you carefully consider which options to swap into with what expiration based on your target price, and how long you plan on owning.  You should plan on selling it with at least 30 days left till expiration, and use an options profit and loss calculator to determine which seems like the best choice based on the date you want to sell it, and the price range you expect it to be at, and the corresponding value of the option.

Disclaimer: I have done something similar to the example above with (TBSI: 4.09 -11.85%), and used a portion of my original investment to go into (GNK: 7.44 -19.31%).