BHP is a stock that has had a wonderful run of late. Wouldn't it be nice to lock in the gains of the current upward move while removing the downside risk associated with volatility? For readers who had the opportunity to own the stock from the double bottom formation in early January 2007, this article may be of interest to you.
An entry may have been taken using the first higher swing bottom rule off the second of the double bottoms on January 11th, 2007. Using the closing price of $24.62, 1000 shares could have been purchased at a cost of $24,620. Chart 1 shows the technical set-up and the first higher swing bottom entry zone. Holding these shares to the current price of $29.32 at close of business on February 26th, 2007, a tidy unrealised profit of $4700 (($29.32 - $24.62) * 1000 shares) is in the hand.
Chart 1 â BHP Daily Bar Chart
The question then arises. Can the unrealised profit be protected while still maintaining the ability to make further profits? Of course the answer is yes, by the use of options. By buying a Put option for protection and selling a Call option to finance the Put option, a "Collar" has been created to help lock in profits and still maintain the potential to make more profit.
Chart 2 shows the risk graph of the adjusted position by hedging the stock for the next 60 days. The position shows the result of buying 1 Apr 07 29.00 Put option and selling 1 Apr 07 31.00 Call option for a total debit of 0.415c (1.045 â 0.63). Selling the Call option reduces the cost of the Put option to 0.415c instead of 1.045c which is the full cost of the Put.
The downside is that by selling the Call option, it limits the upside profit potential of the trade. However, this limitation is only in place for 60 days and a decision will need to be made as to whether BHP can get above $31.00 within the 60 day period.
Chart 2 â BHP Adjusted Collar
By setting up the trade it can clearly be seen the downside risk has been removed from the trade. If BHP trades at any price below $29 over the next 60 days, a minimum profit of $3965 will still be made. This would be in contrast to owning the stock where the profit would be diminishing as the stock trades lower than $29.
Using Collar trades to hedge stock for short periods of time is an excellent way to trade short term pullbacks in stocks. It also gives a trader peace of mind as a minimum profit will be locked in for the duration of the Collar.
Manage Your Risk!