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How To Protect Your Profits ... And Still Stay Long

 December 24, 2010 04:06 PM
 


2010 HAS INDEED BEEN AN INTERESTING YEAR IN THE MARKETS, WITH ALL THE MAJOR INDICES NOW ECLIPSING LEVELS NOT SEEN SINCE THE COLLAPSE OF LEHMAN BROTHERS IN SEPTEMBER OF 2008.

The bulls will no doubt have plenty to cheer about as the Santa Claus rally puts the exclamation mark on the already impressive gains.

Since July 1st, the Dow, S&P 500, and the Nasdaq Composite have seen gains of 19%, 22% and 27% respectively.

The question now on every investor's mind is this:

How much is left in the tank? 

It's impossible to know definitively when we'll get a pull back, or how intense it will be.  Eventually the markets will correct, but having cleared some pretty key levels of resistance, there is plenty of meat left on the bone if we go higher from here.

The market has been clearly intent on finishing 2010 very strong.  It's shrugging off daily downgrades of European Sovereign credit ratings, persistent high unemployment, a sluggish housing recovery, potential military conflict on the Korean Peninsula, and the tightening measures in China to slow down inflation.

Instead, the market is feeding off the very loose monetary policy employed by the Federal Reserve (QE2), the ECB's stepped up measures to buy shoddy European debt to contain the crisis, and the newly minted fiscal stimulus that was attached to the tax cut extension bill, which prompted economists to ratchet up GDP estimates for 2011.


When Will "Rally Mode" End?

There are many signs that we are potentially close to a market top.  The market internals and breadth are losing their strong momentum, but still maintain a bullish advance.  The price action is consolidating with tighter trading bands as the sloping pattern flattens.

The American Association of Individual Investors is showing overly bullish readings eclipsing the April highs that correlated with that market top.

Bullish sentiment hit 38-month highs, according to the latest reading from Investor's Intelligence, which polls the mood of financial advisors.

And today, the S&P 500 volatility index (VIX) -- otherwise known as the "fear" index -- closed at 15.45.  That is not only below the low set from the April market top, but the lowest reading since July, 2007!

The point here is that when there is so much bullishness, that's got to be bearish.  Overbought does not necessarily mean over, but the market is prime for a correction.

Below is a 1 year daily chart showing the VIX hitting a new multi year low ...

(Click on chart to enlarge)



How to Stay Long and Strong … And Protect Your Profits

Not only is the VIX a contrarian sentiment gauge, but it's a measurement of how expensive options are in the market place.  After all, options are an insurance instrument, and when there is fear of a market decline, prices rise.  When there is complacency or lack of fear, option prices deflate.

With all the bullish sentiment, high equity prices, and being that the next two trading weeks will be shortened by Christmas and New Years, the price of options have been slashed like big ticket items at Best Buy!

By selling out your long stock positions and replacing them with some well placed CALL options, you can reap many benefits ...

Lock in your profits

Free up your cash flow

Maintain equivalent bullish positions to capture further advance

 

A Practical Example

Let's say you are long 1000 shares of Qualcomm (Sym: QCOM).  The stock has had a nice run and is sitting at 2010 highs, closing yesterday at $49.99.

Below is a daily chart of QCOM ...

(Click on chart to enlarge)



If the rally falters, your profits are in serious jeopardy.  However, if the market rally has more legs, QCOM will most likely trade higher.

If you sell your 1000 shares, you will book your profits and have nearly $50,000 added to your cash position.

To replace the stock position, consider buying 10 February 50 Calls.  10 Call contracts will control 1000 shares of QCOM, which gives you the right to buy QCOM at 50.00 (strike price).  The cost of the Calls are $1.99 per contract -- or $1990 for the entire position -- with the stock trading $49.99.  You put $48,000 back in your account, and spend $1990 to maintain control of the 1000 shares.

The Calls are only .01 out of the money, so as the stock advances, the Calls will immediately go In The Money.

QCOM reports earnings around January 24, so the potential price moving catalyst is included in your expiration cycle (your options will expire on Feb 18).

If the market does sell off, you have locked in your profits, less the cost of the cheap Calls.  The Call position is essentially acting like a $2.00 PUT position -- or a stop near $48 per share on your stock.  The other benefit is the cash flow being freed up as well.

Using well placed stock replacement options is a great way to free up cash flow, lock in profits, AND maintain a bullish position.

Look for opportunities like these in your portfolio, and remember this big tip:  Find the option month that includes the earnings release date, which will be a big boost to maintaining the optimal valuation of your cheap option and capture the news release that may move the stock price.

This strategy sets up perfectly for the current market scenario, heading into Q4 earnings season for investors who want to maintain bullish positions.

My very best to you and your family for a Happy and Healthy Holiday.
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