Lower Risk and Higher Profit? Here’s How
Over the past few weeks, we have seen some momentum shift back into the technology sector, in spite of continued valuation concerns and a lack of any sustained capital spending. Some of the buying I’m currently seeing in the tech sector reminds me of the heady days back in 2000.
You may now be at a juncture where you are deciding whether to take some profits or move on. Liquidating your entire position could see you miss out on additional gains. So, what do you do?
A stock displaying strong Relative Strength and momentum is Internet search engine Google Inc. (NASDAQ/GOOG). The near-term technical signals and trend are bullish, but, given the rapid price appreciation, the stock is also now showing some overbought signs and potential selling.
Let’s say you were fortunate and purchased Google at the opening day IPO price of $100 back on August 19, 2004. At Tuesday’s intraday high of $299.59, you would be up 199.59% in less than a year. Again, do you take the profits and move on? It is a difficult decision. Fortunately, I’m here to help you.
You want to ride any trend as long as possible and maximize profits, but, at the same time, you don’t want to be greedy and watch your gains fade away. Always keep in mind that the key for successful trading lies in managing risk.
If you ask your broker, he or she may say that the best solution is to take some profits. I agree with this strategy, but I will add a minor variance that could make the trade more rewarding.
What I suggest is that you divide the position into three parts. Assume Google is trading at $299.59, and you own 900 shares. You should cash out on 300 shares and take the profit of $59,877 (excluding commissions). Next, you’d want to ride out the trend with 300 shares, but keep a stop-loss on Google at about 10% below the current trading price. The actual percentage used will depend on your preference, but be warned that setting a low stop-loss at, say, 5% or less could take you out prematurely, especially in a stock like Google that has major swings.
Last, it might be a good strategy to write Covered Call options on Google. I actively write Covered Calls on my outstanding positions, as it gives me a predetermined selling price and generates some premium income that allows me to lower my adjusted cost base for the stock.
For example, let’s say you want to allow Google some time to trend higher, so you decide that January 2006 makes sense. Given this, you could write three contracts (equating to 300 shares) of January 2006 $350 Google. This means you are willing to sell 300 shares of Google at the strike price of $350. For writing the Covered Call, you receive a premium of $1840 per contract, or $5,520 for the three contracts. This is the premium you get for taking the risk of a potential exercise.
Ultimately, who cares if you have to exercise the call, since you get to sell Google at $350, a 16.83% gain from the current price. Now, assume Google trades at $350 prior to exercise in January 2006. You sell 300 shares at $350 for a profit of $75,000 (excluding commissions), plus the premium of $5,520.
After the exercise, you still have 300 shares of Google riding the trend and have realized profits of $140,397 on 600 shares. Your total combined realized and unrealized gains are $215,397. Compare this to the $199,590 in profits you would have made if you had liquidated the entire 900 shares.
Not that bad for a relatively low-risk trading strategy! In future columns, I plan to present more trading strategies to help make you a better trader. In the meantime, remember that the trend is your friend and that a little risk management can only help your portfolio.