Use Puts to Lock in Profits

One of the hardest things to know when investing in the stock market is when to sell a profitable position. Most people are happy to get a 20% gain on an investment unless they sell and watch the stock go up another 200%. Or what about watching an investment that is up 20% fall back a little? Do you sell for a 15% gain or keep watching and hoping that it will turn back around? Do you keep waiting as it keeps falling, hoping and watching? How many times have you watched a paper profit turn into a loss since you were sure it would bounce back only to watch the stock continue its decline?

Wouldn’t it be nice to get rid of some of that guesswork regarding when to sell? Enter the put option. Here is one way that you can use a put option to lock in gains but still leave room for additional profit if the stock continues to climb. In my 401(k), I own stock in Goldcorp (GG). It recently made a run from under $30 per share to almost $40 per share as the price of gold climbed nearer to $1000 per ounce. I know that $1000 per ounce for gold is a major psychological hurdle and serves as a major resistance. I was concerned that GG would fall back quite a bit if the gold price couldn’t surpass that hurdle.

So, I purchased some June 40 puts for $1.65 per share. What does that mean? That any time between the moment of purchase until the third Friday of June 2009, I have the option of selling my GG shares for $40. Plus if on the close of the market on June 19, 2009, GG is selling for less than $40 per share, my shares will automatically be sold.

What good does this do me? It takes away the concern I have whether to sell now or not. The decision is made. I will get a minimum of $40 per share regardless what happens. If GG is trading at $50 in June, I still have my shares and I benefit from the increase of $10 minus the $1.65 premium that I paid. If GG is less than $40, I will get the $40 per share anyway and could buy back GG ending up in the exact same position. If GG is less than $38.35, then I actually came out ahead of where I would have been otherwise.

Like I said, the decision has been made and I don’t have to fret over what to do. If GG is at $50, then I got the majority of the increased profit and will just buy a $50 for July or August. Eventually, GG will drop and I would just buy it back for a cheaper price. In this way, I can trade around my core position in Goldcorp stock.