Stock Replacement Strategy: Locking in Profits

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Stock Replacement Strategy: Locking in Profits

When you have a profitable position in a stock you bought, you can often lock in most of those profits, while still taking advantage of further upside price movement.

How? Simply replace your stock with a call option. Hereís an example.

Letís say during the late spring or early summer you had purchased 100 shares of Deere (DE) at $57. As you can see from the chart, the stock closed at 66.68 on July 30:



You might be thinking about selling some or all of your shares to lock in some of those gains. Another approach? Sell your stock and buy a call option to replace it.

There are plenty of alternatives to choose from, but I took a look at the options that expire in January 2011. The 60 call for that month costs $1,015.

Hereís how you might have traded this strategy based on the July 30 close (commissions not included):

Your original investment of 100 shares: $5,700

Sell 100 shares: $6,668

Buy 1 January 2011 60 call option: $1,015

New net investment: $47

This chart shows the profit outlook for this strategy at expiration ñ comparing stock replacement with continuing to own the stock.

Although by replacing your stock with a 60 call, you make less as the stock rises, but your maximum loss is now only $47 ñ even if the stock plunges.

Adding a short call

In addition to buying that call, you might also sell another call option at a higher strike to collect some extra premium ñ creating a bull call spread. This is when youíre long one call and short another at a higher strike price (which requires level 3 options approval at Zecco Trading).

In addition to buying the 60 call option, you might have also sold the January 2011 75 call option for $264 (as of July 30). Based on this scenario, this would lock in a profit of around $200 as shown on this chart:



With a bull call spread in place, youíve locked in a higher gain than basic stock replacement anywhere below $75, but the short 75 call caps your maximum profit to approximately $1,700.

Whether you use a bull call spread or not, you can use stock replacement to prevent losses and free up capital for other investments.

And depending upon which expiration you choose, you often have plenty of flexibility to take a short-term or long-term view.

Of course, you will need to consider some caveats in determining if this strategy is suitable for you, including booking profits as long term vs. short term gains. More on that subject in a future post.


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