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KNOWING WHEN TO SELL A profitable stock, and bank the profits, is one of the toughest decisions any investor or trader ever makes. No one wants to run the risk of stepping out of a stock that seems poised to rally even higher.
As this conundrum becomes increasingly common toward the end of second-quarter earnings season, and concerns remain about the stock market's trajectory for the remainder of 2010, options strategists are starting to advise clients to consider a trading strategy that effectively lets them have their cake, and eat it too.
The prosaically named stock-replacement strategy simply entails selling a stock, and replacing the shares with a bullish call option. When the dean of the options strategists, Michael Schwartz, helps clients implement this strategy, he typically advises them to buy a call that expires in at least a year.
"You want to buy as much time as possible to get a long-term capital gain on the position. If you buy a short-term option you pay the higher short-term capital gain," says Schwartz, Oppenheimer & Co.'s chief options strategist.
AT GOLDMAN SACHS, the bank's influential derivatives strategists, John Marshall and Maria Grant, are taking a different tack. They see an opportunity to make short-term stock-replacement trades that take advantage of unusual dynamics that have recently emerged in the stock, options and credit-default-swap markets.
Marshall and Grant are telling clients that options prices are inexpensive. This means that anyone who implements the stock-replacement strategy can effectively sell their stock high, and buy options low, because implied volatility levels are effectively pricing options contracts with little to no risk premium.
"Positive earnings announcements have calmed the equity and options markets very quickly over the past month. The Standard & Poor's 500 Index is up 10% in the past month and stock implied volatility is down 30%," Marshall and Grant averred in a recent note to clients.
Though it seems that the stock market faces few bearish catalysts following the completion of the European Bank stress tests, the yield spreads on corporate credit-default swaps—essentially insurance on corporate debt—are still at relatively wide levels, possibly presaging future stock-price volatility.
That signal is in sharp contrast to the message in the options market. The average stock's three-month implied volatility is 28%, which Marshall and Grant say seems somewhat low at this stage of the economic recovery.
The strategists have told clients to use inexpensive options on stocks that have outpaced the market to reduce risk of stock ownership, while also maintaining upside exposure to any future stock gains.
Unlike Schwartz, Marshall and Grant are telling clients to buy calls that expire in three months–that is the September expiration—on a list of stocks that are trading at prices above their one-year average price.
The trading menu includes: Las Vegas Sands (ticker: LVS), Sprint Nextel (S), Wynn Resorts (WYNN), Coca-Cola (KO), Ford (F), Caterpillar (CAT), l ConocoPhillips (COP), UnitedHealth Group (UNH), Starwood Hotels (HOT), Continental Airlines (CAL), Corning (GLW), Harley-Davidson (HOG), Juniper Networks (JNPR), Citigroup (C), International Paper (IP), Netapp (NTAP), UPS (UPS), Halliburton (HAL), and Deere (DE).
If the economic hobgoblins derail the stock market, the stock-replacement strategy will prove to be worth its weight in gold. Whether you decide to use the stock-replacement strategy for three months or more than a year is simply a matter of personal taste. Both approaches will let you balance your risks, and your rewards, which is all that really matters.
E-mail: editors@barrons.com
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