How to sleep well when holding an overbought stock?

Ever wonder why some investors sleep well at night when markets are at all-time highs while others can’t? The eclectic investor is one of them; he sleeps well while the average investor worries. The reason is that the eclectic investor knows how to use insurance strategies in his portfolio.

At some point in your investing career you will own a stock that, after thorough analysis, you will believe to be overbought. You will think that it is more likely to go lower than higher. What should you do? The average investors will sell or hold. The eclectic investor has a third option: the collar.

Let’s say you own an overbought stock and decide to keep it because you believe that, in the long run, it is still a good investment. However, you’d like to guard against a downturn in the stock. This is when a collar would help you. The collar is built by buying a PUT which gives you insurance in case the stock drops and by selling a CALL which pays you premium that is used to pay for the PUT. You give up some of the upside by being short in the CALL, but you protect the downside by owning the PUT.

Here is an example:

Let’s say you bought stock ABC a year ago for $60, and now, it’s being traded for $100. The stock is at all times high and has run up over 66% in 52 weeks. You believe it is a bit overbought, and might go down. But, you don’t want to sell because you expect that, over the long term, it will be a consistent performer. Also, you don’t want to sell and have to pay taxes on capital gains. So, as an eclectic investor, you buy a collar to protect the position. Here’s the setup:

· Own 100 ABC Stock @ $100

· Buy a PUT (with 60 days to expiration) with strike price of 90 for $2

· Sell a Call (with 60 days to expiration) with strike price of 105 for $2

· The collar cost you nothing because the $2 paid for the PUT was offset by the $2 you received by selling the CALL.

Now your ABC position is insured for the next 60 days. In 60 days you will have three potential outcomes:

1) ABC is trading below $90. Your loss is capped at ($10) which is $100 – $90. If the stock were trading at $70, you would have avoided $20 of losses.

2) ABC is between $90 and $105. You have the same outcome as if you owned only the stock without any collar.

3) ABC is trading above $105. Your profit is capped at $5 which is $105 – $100. You’ll be forced to sell ABC at $105 because your stock will be called by the call option you sold. You gave up the upside above $105.

In this case we used an option strategy to protect profits in a stock in your portfolio. We took a position that is overbought that you wanted to keep and we “collared” it to protect against a downturn. This lowered the risk and allowed you sleep well at night.

I hope this example encourages you to think eclectically. Continue learning and adding useful strategies to your investing toolkit.

Thanks for reading. Have a great investing day!

Please note: I reserve the right to delete comments that are offensive or off-topic.

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  • http://www.eclecticinvestor.com/ Dennis Chen

    Martin,

    There IS a difference between a PUT and a trailing stop. When you use a PUT to protect your portfolio the protection is active 24/7 until the PUT expires. A trailing stop works while the market is open. However, if there is a gap down overnight in the stock you have trailing stop programmed the stock might open below your stop. Therefore your stop will not be triggered and you will lose money.

  • martin

    i dont get it… so what’s the difference with a trailing stop? isn’t this a bad suggestion to fellow investors? trailing stop is much better than the “PUT” your trying to “put” in our head. atleast a trailing stop would give you the possibility of gaining more and putting a stop on potential losses… geeez, amateurs…