'Replace' your investments and profit whatever the market does
Amid all the uncertainty about when the rally will end, Theo Casey looks at 'stock replacement' – a strategy that lets you profit whichever direction the markets take.
Whatever your slant, be it bullish or bearish, we can all agree on one thing the markets are always right. And though the recent market performance seems too good to be true, as investors we must accept it, despite our concerns.
You see, the things that have popped bubbles in bear markets gone by aren't doing so anymore.
When China fell into bear market territory on 27 February 2007, the whole world threw a wobbly of epic proportions. Not this time. When average stock valuations topped 30 times earnings on 31 December 1999, collective profit taking led to a big drop in prices. Not this time.
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The valuation bubble of 2009 appears to be made of stronger stuff. This time around, the market seems capable of shaking off any such bad news.
However, all good things must come to an end. We just don't know exactly when that will be. And, in the meantime, you don't want to miss out on the rallies. So we have an idea for investors just like you.
"Replace" your investments. Let me explain
Have your cake and eat it too
The dilemma is a familiar one. You want to buy stocks and ride the bullish momentum. But, your head says no. You don't want to lose out if and when the tide turns against you.
There is a way to have it both ways. A way that you can have a stake in the great market "melt up" and protect your pot in case of a market turn around. It's a very simple strategy and now might be the best time to do it.
You simply sell your existing stock holding and simultaneously buy 'at the money call options' in the same position. This way you are carrying on the trade for a specific length of time for a fraction of the cost. It's called a "stock replacement trade."
Let's say you originally had a £5,000 position in BP shares and you took profits. If you now buy one call option contract, you'll have the same £5,000 exposure, but risking a fraction of the money. And you can put the remainder of the proceeds of your share sale to work in another investment of your choice. You will also protect your portfolio in case the stock falls right back.
You may wonder why this is better than simply sticking the standard 15%-25% stop loss on BP. The problem is that to have a practical stop loss, it must be placed further from the trade than would necessarily be cost effective.
What's the risk?
Simply the premium you pay for the option. You can lose all of this if the stock is below the strike price of 500p when the option expires. In this case, £400, or whatever you pay to buy one contract. If the market collapses, you simply take a loss on the option, but it will not affect your original return from BP.
If you're new to buying options, click here for Brian Durrant's helpful introduction.
How to place the trade
It's important to note that this is a strategy available to nearly 100 of the top UK blue chips. Here's a shortlist of certain available positions you may own that can be "replaced":
For the full list of UK stock options, visit www.euronext.co.uk.
To action the trade, you simply ask your broker to place an order to buy one at-the-money call option contract for the stock in question. The downside will be limited to the amount you pay for the premium but your upside potential is infinite.
If you're looking for a broker to guide you through the process, you can get in touch with the experts: Ian Thurgood at ODL securities on 0207 903 6150, Marc Quinn at Berkeley Futures on 0207 758 4777 and Julia Williams at Sucden on 0203 207 5680. Just mention that you read about this in The Right Side from Fleet Street Publications.
The higher the price of the shares goes, the higher the premium of your call options will be. The aim would be to close the option position for a profit as the price of the company continues to ride up. If the price of the underlying shares was to fall and was below the strike price when the option expires, you would lose the small premium we pay for the options but no more.
The private investor now finally has the opportunity to have his cake and eat it.
This articlewas written by Theo Casey, investment director of theFleet Street Letter, and was first published in the free daily investment emailThe Right Sideon 26 August 2009.
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