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HOW TO PROTECT A BIG PROFIT

By Jim Pearce • June 26, 2023 • Stocks to Watch

Printable PDF

Last October, I added NVIDIA (NSDQ: NVDA) to the Personal Finance Growth
Portfolio. At that time, growth stocks were taking a beating. The Fed was
aggressively raising interest rates with no end in sight.

From its peak above 13,000 in August to its nadir below 11,000 two months later,
the tech-heavy NASDAQ Composite Index fell by more than 20%. Over the same span,
NVIDIA lost more than double that amount!

That’s when my contrarian instinct kicked in. I don’t pretend to be a savant
when it comes to tech stocks, but everything I do know about investing told me
that NVIDA had become grossly oversold.

I thought long and hard about pulling the trigger on that trade. I couldn’t help
but wonder what the rest of the world saw that I did not.

After triple-checking my analysis, I decided I was right and they were wrong. As
I advised my readers, “The best time to buy a stock is often when the market is
down and nobody wants it.”

In this case, my timing was nearly perfect. Two days after that buy alert was
issued on October 12, NVIDIA closed at its lowest price in more than two years.
It hasn’t traded below $115 since then.

In fact, NVIDIA has taken off like few stocks I have ever seen. Over the past
eight months, it has more than tripled in value.

Five weeks ago, it traded above $300 for the first time ever. Two weeks later,
it crossed the $400 mark. At its current pace, it could soar above $500 by the
end of this month!




A NICE PROBLEM TO HAVE

As I told my Personal Finance readers a few weeks ago, watching a stock
skyrocket in value shortly after buying it is a nice problem to have. Having a
big gain on paper is wonderful. However, it also creates the dilemma of how to
protect that profit when the stock eventually loses momentum.

If I sold NVIDIA now, my capital gain would be short-term. That’s because the
holding period would be less than a year. In that case, the profit would be
taxed at the same rate as my ordinary income (if the gain is realized in a
non-taxable account such as an IRA, then it is not taxed until withdrawn).

I could wait until October to sell it so that it is taxed at the lower long-term
gain tax rates. However, there is the risk that some or most of my profit could
disappear. For reasons I cannot foresee, NVIDIA could hit the skids between now
and then.

The other disadvantage to selling it now is that I would miss out on any future
capital appreciation. For all I know, NVIDIA isn’t going to slow down until it
hits $1,000 a share.

The good news is there is a solution to both problems that is easy to implement.
I could buy a put option on NVIDIA that does not expire until after I have held
it for at least a year.

For the uninitiated, a put option is a contract that allows the buyer to force
the seller to purchase a stock at a set price within a specified timeframe. The
buyer pays the seller a premium to accept the risk that the price of the stock
will drop below the option’s strike price prior to expiration.


INSURANCE POLICY

For example, on June 13 while NVDA was trading near $407, the put option that
expires on October 20 at the $365 strike price could be bought for $25. If NVDA
drops below that price within the next four months, I could execute that
contract and assure myself of selling the stock for $365 even if it falls far
below that price.

Since I paid $25 for the right to do that, the breakeven price on this trade is
$340. That is 16% below the share price for NVDA that day, which would be my
maximum loss in this example (excluding brokerage fees). And if I bought the
stock on the day we issued our buy alert, by the time this option expires the
gain would be long-term and subject to a lower tax rate.

Now, suppose NVDA keeps going up. In that case, I am out the $25 options premium
but would fully participate in whatever share price appreciation occurs until
the option expires. At that point, I could sell the stock after holding it at
least twelve months for it to be taxed at the long-term capital gain rate.

The same strategy can be used for any other stock you own with a big gain that
you would like to protect. It comes at a cost, like buying homeowners insurance
to protect your house from a fire. You hope you never have to use it, but it is
nice to know it is there in case the unexpected happens.

That is just one example of the many ways options can be used to reduce risk and
increase returns. There are other ways you can improve your investment results
with options, including the strategies used by my colleague Robert Rapier.

As chief investment strategist of Rapier’s Income Accelerator, Robert has
developed strategies that make money in bull or bear markets.

Robert Rapier can show you how to squeeze up to 18 times more income out of
dividend stocks, with just a few minutes of “work” each week. Click here for
details.

Subscribe to the Investing Daily video channel by clicking this icon:


ABOUT THE AUTHOR

Jim Pearce
Bio | Archive

Jim Pearce is the Chief Investment Strategist of Personal Finance, our flagship
publication, and manages two trading services, PF Pro and Mayhem Trader. He
began his career as a stockbroker in 1983 and over the years has managed client
investment portfolios for major banks, brokerage firms, and investment advisors.
Jim earned a BA from The College of William & Mary and the CFP designation from
the College of Financial Planning.

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