You Nailed the Bottom, Now What?

• stevenplace
• July 7th, 2010

Let’s assume for the moment that you’re one of these stock market gurus who just happens to be able to buy at the exact bottom of a market turn. This doesn’t happen, but I want to show a method of taking profits that cuts your risk, your directional exposure, and nearly guarantees a profit.

The most recent low on the SPY was 101.13– for the sake of the argument and this lesson, I will say that I bought 100 SPY at exactly 101.13, because I’m a genius. The question is, what do you do now? Obviously, you could take a profit, but that would eliminate further profit potential. Luckily, you can do a call conversion, where you sell your stock and convert it to calls.

Let’s look at our initial risk profile:

Clearly, “Max Risk” is a little unreasonable, unless you pull a Prechter and expect the collapse of the equities market; however, it’s going to be useful in a second.

So what we’re going to do here is sell the stock, and buy a call. Specifically, we’re going to buy the Aug 105 Call. Here’s the new profile:

So what happened here? Well, you cut your risk in half (delta went from 100 to 50). You also rolled into a risk free trade, and while you have the risk of giving back all your gains, you also keep the potential for higher reward. The cash required got cut by a factor of 13, and you also get a gamma “kicker” by owning options.

If the market continues to rip and you do manage to pick up some long positions, you may want to consider this conversion as a way to manage risk in this market. After all, everyone was looking for Armageddon just 72 hours ago.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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