CHAPTER 5

Managing Profits and Losses

The conservative risk profile discourages short-term decisions, and speculation is contrary to a safe and sensible investing philosophy. A buy–hold–sell technique is buying well-selected, high-quality stocks, hold for the long term, and sell only when the fundamentals change. This smart investing approach does not preclude protecting profits when price levels become volatile. You do not want to begin as a conservative and end up as a speculator. However, there are ways to take profits without selling stock and without increasing market risks. In some instances, taking market risks makes sense, even though it is not always a wise move.

Begin by making distinctions between various investor profiles. A conservative investor is interested in preserving capital and, as a result, wants to avoid risks. In stock market terms, risk usually refers to volatility (technical risk) or weak financial position (fundamental risk). A moderate investor is willing to assume somewhat greater risks if the potential for higher profits is present as well. A speculator or aggressive investor seeks the highest possible returns—often short term—and is willing to accept the highest levels of risk.

The label you use to define yourself is likely to be challenged when you come to the question of when and how to take profits. Recalling that profit-taking normally involves selling stock, it is contrary to your conservative profile to dispose of stock you would rather keep. But when you involve options, your choices expand significantly. Option strategies provide methods for protecting paper profits as they exist today, making smart moves when market conditions change and taking profits without needing to sell stock.

Your Conservative Dilemma

A conservative policy is intended to protect your investments from loss. By selecting high-quality companies, you eliminate the volatility that threatens your portfolio’s value, and you set the goal of building equity over many years. Even so, you must contend with ever-changing market conditions and the prospect of needing to modify your mix of stocks. The most readily available information is short term by nature, so you must continually ensure that your portfolio-based buy–hold–sell decisions are made using valid information.

Reacting to short-term indicators and trends is human nature, but it can adversely affect the timing of decisions in your conservative portfolio. The conflict between short-term market trends and your long-term mindset is efficiently managed with options. Used in the proper context for managing price volatility and not as a primary and speculative change in policy, options help smooth out the price volatility that characterizes the market while protecting profits.

Deciding How to Establish Your Policies

If you have observed trends over time, you know that the price gyrations occurring this week and this month have a short-term aspect and a long-term aspect. You are keenly aware of what occurs from one day to the next, and you see daily reactions to political and business news, to earnings surprises, to rumors of economic trends, and to an unending number of other reasons for prices to rise or fall. But in the long-term context, short-term price changes and the daily reasons for price volatility really have nothing to do with long-term value. It is most logical to invest in high-quality stocks, monitor the fundamentals, and ignore short-term trends altogether.

Even the most ardent fundamental investor may not want to take this approach exclusively. Profit-taking is tempting. There is a way to take profits without selling stock. Some forms of trading can be made with little or no market risk. In Chapter 6, you see how covered call writing using appreciated stock achieves this end.

Selling stock when its price demonstrates short-term change is usually contrary to your conservative strategy. However, rapid price movement may also signal a change in the company attributes. Using any strategy does not necessarily contradict your conservative rule.

Managing Profits with Options

Investors often ignore the real problem of “managing” profits. (It may seem odd to refer to the “management” of profits because the usual thinking is you either sell to take profits or leave them intact; but, in fact, management is precisely what you want to do, even when your primary emphasis is on long-term growth.)

The traditional suggestion to buy long-term stocks and ignore short-term volatility is generally good advice. But ironically, it may also be irresponsible to simply leave it as such. Your ongoing portfolio management involves many chores, mostly centered on monitoring fundamental indicators. If corporate strength, competitive position, dividend payments, earnings trends, capitalization, and other fundamentals change, you may decide to sell shares and redirect your capital elsewhere. This is basic and sensible.

Basing Decisions on the Fundamentals

Conservative portfolio management is based on the fundamentals. Short-term price volatility—a technical indicator—can also be an early warning of emerging changes in the fundamentals. If volatility is a symptom of other problems—notably, of changes in fundamental strength—watching prices carefully is sensible. It is not reliable, however; most market theories agree that short-term movement cannot be used as a predictive tool. When prices are volatile, this may serve as a signal seeking confirmation that the fundamentals still work.

If price volatility is related to a serious decline in fundamental strength, it helps identify a change far earlier than traditional methods. Price volatility does not consistently provide early signals; much of the short-term volatility represents marketwide short-term trends, overreaction to news and events, or buying and selling trends among institutional investors who have little or nothing to do with the stock’s long-term growth potential.

The traditional advice given to conservative investors wanting to ensure safety is to diversify their portfolios. Although diversification is a sensible idea, it does nothing to contend with short-term price volatility. Even with the best diversification, you still experience price surges and declines; you still want to take profits or buy more stock at depressed prices; and you must resist the temptation to react to short-term trends for the wrong reasons. Diversification protects you against specific risks, but it does nothing to ensure that you will not have to live through price volatility.

Yet another expansion of the diversified portfolio is to adopt a model for asset allocation. Under this variation, you “allocate” portions of your capital in different markets: stocks, mutual funds, real estate, cash reserves, precious metals, and so on. Asset allocation makes sense for the same reasons that diversification does, but it does not protect your portfolio from short-term volatility.

The Reality of Risk

You cannot avoid all forms of risk. But you can protect yourself. The two methods of protecting profits with options are buying puts and selling covered calls. Each of the attributes of these strategies is worth comparing. Table 5.1 summarizes features of the long put and the short call.

Table 5.1 Long put and short call features

Buying puts	Selling calls
This provides a form of insurance on long stock holdings	This sets up a contingent sale in the event of exercise
Stock price decline sees decreased put premium value	Stock price decline is offset by reduced call premium value
Price offset is unlimited as long as the put remains open	Price offset is limited to premium received
A trader pays to acquire the put	A trader is paid for selling the call
Time value decline may offset ITM gains	Time value decline is profitable in the short position

The decision to use long puts or short calls rests with your long-term opinions about long or short positions. If you view long puts as strictly working to provide insurance, it is conservative to protect profits without risking stock positions. In comparison, covered call writing presents the possibility of exercise in exchange for money flowing in rather than out and for providing a reduction in your basis, thus programmed higher profits in the event of exercise. This downside protection makes short calls more attractive in most respects. However, if you view covered calls as inappropriate because you do not want to have shares called away, the long put may be the best method for protecting your profits.

Overcoming the Profit-Taking Problem

The debate about whether it is conservative to use options depends on the timing and motives behind your decision. Buying options to speculate is inconsistent with your conservative goals.

You need to identify the lowest likely price level for the stock. Support is a technical term, of course, and most conservative investors do not use support and resistance as decision-making tools. An understanding of the support level within your conservative risk profile helps you coordinate option strategies that enable profit-taking without needing to sell stock.

Realizing Profits Without Selling Stock

As a conservative investor, you do not want to make profits just because the current price of stock is higher than your basis; it would certainly be desirable to realize profits without selling stock. A few guidelines help clarify this dilemma:

1. It is appropriate to use long puts to protect existing portfolio positions. The long put, as insurance, represents a limited risk and ensures that current profitable price levels are protected.
2. It is appropriate to use long calls only as a form of contingent purchase, when long-term options (LEAPS) are available and when the purpose is to reserve the possibility of exercising those calls to purchase shares of stock. (See Chapter 9 for more in-depth discussions.)
3. Long calls are useful if prices of stocks you currently own have fallen rapidly due to marketwide price declines; this presents a buying opportunity, but you may be unwilling to purchase additional shares as a means of exploiting the temporary condition. Calls can be exercised to acquire additional shares to reduce your overall basis in the stock.
4. Short puts are useful as a form of contingent purchase (in which you would have shares put to you at the strike price when exercised), but only when you would be pleased to purchase shares at the net price (strike price reduced by put premium you receive). Support level is by no means an absolute value. You may employ fundamental tests to find what you consider the stock’s support level.
5. You can use short puts in place of long calls when prices of stock you own have declined and you expect near-term prices to rise. This assumes you are willing to acquire shares at the strike if the put is exercised.

When is the decision to employ options speculative, and when is it a valid conservative strategy? One consideration is whether you already have a position in the stock. If your purpose in using options is to protect profits, exploit price swings, or average down your cost of stock, your conservative standards are compatible with using options in a variety of ways. If you use options to time market price movement in stocks you do not own, it is only appropriate for contingent purchase strategies, qualified by the preceding conditions. Otherwise, using options just as a means for profiting in stocks you do not own is speculative.

When a Rescue Strategy Is Appropriate

This rescue strategy is any decision designed to recover from a loss in one position, by offsetting that loss with a new position. This is appropriate only when (a) fundamental strength continues to qualify the stock as a long-term growth investment; (b) you have capital available to purchase more shares or to trade options; and (c) you are willing to invest in a single stock, either through equity or options. The drop in price levels could be a problem; however, if the fundamental value of stock has not changed and you want to continue to hold shares, a rescue strategy helps reduce basis and offset a past loss.

Another rescue strategy following the acquisition of stock through exercised short puts is to revert to a covered call strategy. The outcome of this strategy is positive from all angles:

• You buy more shares, but your basis is reduced to the average between original shares and newly acquired shares.
• You earn a premium from writing short puts and short calls, all of which is yours to keep.
• You have a capital gain on the shares acquired and then called away.
• You come out of the series of transactions with the original number of shares after exercise, which is unencumbered and can be held for long-term growth (but at a lower basis), or to provide coverage for additional short call positions.

If puts are not exercised, you could wait for expiration or close prior to expiration at a profit. Once they are expired or closed, you can write more short puts. However, if the price of stock rebounded during the life of the puts, you would not want to repeat the short put strategy, at least not at the same strike. If the puts’ value declines, you can enter a closing purchase transaction. The net difference between your original sale and later purchase is profitable.

The greatest problem with strategies like this is the complexity of the transaction. To execute a series of trades involving short puts and short calls, changes in basis, and the number of shares owned, some conservative investors are understandably discouraged. It requires confidence and skill to deal with the details. Considering that the purpose of the transaction is to manage a decline in market value and to turn it into a profitable position, it is worth overcoming the initial learning curve. However, you should also ensure that before you enter the short positions, you fully understand the potential consequences, as well as the benefits, of every possible outcome.

Taxes and Profits

The strategies you employ to either protect paper profits or minimize paper losses may be profitable or not, depending on your tax status. If a profitable or breakeven situation is calculated on a pretax basis, it may end up at a net loss after tax liabilities are calculated.

To assess strategic decisions with tax liabilities in mind, include the following points in your analysis:

• Carryover loss status. As a planning tool, carryover losses are easily forgotten or ignored. If your carryover loss is substantial, you may absorb that loss by taking gains this year that you might not have taken otherwise. As inconvenient as carryover losses are, they provide a planning opportunity.

  A sale of stock should occur without use of options. Upon sale, wait 31 days before repurchasing stock to avoid the wash sale rule, or sell ITM puts at the strike price close to your sale price.

• Your true effective tax rate. When you calculate the tax effect of capital gains on stock or options, be sure to include both federal and state taxes. Your “true” effective rate is the combined rate of both. The effective rate is the percentage of tax on any earnings reported under your tax bracket, where Federal and state effective tax rates must be added together.
• The timing of your profits and losses. Traditional tax planning involves preplanned timing of taxable gains and, equally important, of tax losses. You can time your profits and losses based on your tax status this year. However, your priority in timing of transactions should be set first on your conservative goals. Only when it makes no difference should the tax questions come into play.
• Offsetting profits and losses in the same year. One of the most effective planning devices is to simply match profits against current-year losses. The outcome has little or no net change on your effective tax rate. If your rate is close to the point where additional income would push your taxes into the next bracket, preplanning makes sense. If you intend to take profits, it may also be smart to dispose the underperforming stock. You gain two advantages by coordinating the timing of these transactions. First, you shelter gains by offsetting them with investment losses. Second, you dispose of stocks that have not performed as you hoped.
• Unintended tax consequences. The tax rules for options-related transactions are complex. For many individuals, the tax rules are too complicated even without options, so many people who simply buy and sell stocks, mutual funds, and real estate hire tax experts to help them comply with the law. When you add options to the mix, the complexity makes professional help more important than ever. Consult with your expert before making trades so that you understand the rules and know beforehand which types of trades can cause significant loss of tax advantage.

Options Used for Riding Out Volatility

Everyone must contend with short-term price volatility. As a conservative investor, you focus on fundamental attributes of the company and use short-term indicators only to test your ongoing assumptions. If those assumptions change, your hold strategy may become a sell. However, if you intend to continue holding stock, options can be valuable in riding out short-term volatility as an alternative to profit-taking in the traditional manner. With options, you can minimize short-term losses and even take profits while continuing to own shares of stock.

In the next chapter, the intriguing possibilities of the covered call strategy, including the special tax rules that apply to short options strategies, are explored in depth.

Class questions for discussion and/or mini-case studies

1. The “buy and hold” strategy involves:

   a. Buying stock and holding options on those stocks.

   b. Buying options only and holding until expiration.

   c. Buying and holding stock for a very short term.

   d. Buying stock for the long term and not selling.

2. Price volatility demonstrates that:

   a. Diversification does not solve short-term risk-related problems.

   b. Market risks make stocks inappropriate in a conservative portfolio.

   c. A robust market involves uncertainty without exception.

   d. Relying on fundamental trends is a more sensible way to trade.

3. You can realize profits without selling shares of stock by:

   a. Selling and immediately rebuying the same shares.

   b. Selling and waiting for retracement, and then repurchasing shares.

   c. Trading short or long options and taking profits through options rather than stock.

   d. Executing a series of wash sales to time extreme price moves.

Discussion

Locate the stock chart of a company whose price per share has declined during recent activity. Explain at least two recovery strategies that can be utilized in this situation.