Many stocks have seen significant uptrend in recent times. You must take a decision on whether to sell your shares or hold the long position and protect the downside using options. Accordingly, this week, we compare the replacement strategy (discussed previously in this column) with the protective put strategy.

Realized Vs unrealized gains

Suppose you bought 100 shares of Reliance Industries during the first week of September at ₹2,430. The stock currently trades at ₹2,723. Further suppose you expect the stock to continue its uptrend but fear the possibility of giving-up unrealized gains should the stock decline.

You can consider two strategies to protect your gains. The first one is the replacement strategy. This requires you to take profits on Reliance Industries and use a portion of the profits to buy call options on the stock. The advantage with this long call position is that you may not mind losing time value on the option. This is because you are buying the call using part of your profits and not your trading capital.

Your choice of strike depends on two factors. One, your price target on the stock. And two, the proportion of profits that you are willing to give-up to buy the call option. Note that it is important you buy a strike that is below your price target. This is to ensure that you can capture at least some intrinsic value if the stock moves closer to the target price on the last day of expiry.

The second strategy is to buy a put to protect the downside on your stock. Hence, the term protective put. You must consider two factors before implementing this strategy. One, you must buy the put without taking profits on your long stock. So, that means cash outflow from your trading account. And if you buy at-the-money option, the outflow will be greater compared to out-of-the-money option, but your protection would be better. Two, if the stock declines closer to expiry, the put will lose time value, reducing the protection.

Suppose you buy the 2700 October put on Reliance Industries for 50 points with eight days to expiry. If the stock declines to ₹2,600 two days before expiry, the put could be worth 103 points. So, you have 53 points gain on your put (103 minus 50) against 123 points (2600 minus 2723) decline on your stock. You give-up 70 points (123 minus 53) on your position despite the protective put. If, however, the stock declines 123 points with five days to expiry, you give-up only 60 points. So, the put offers better protection when the decline in the stock is sooner than later. Note that you have to roll over your put in the event you decide to hold your stock beyond option expiry.

Optional reading

You can reduce the time decay on both strategies by setting up spread trades. So, the replacement strategy could be a bull call spread, with the short call subsidizing the cost of the long call. Note that the option you short should be one strike higher than your price target on the stock. The idea is to also capture time decay on the short call. Likewise, the protective put can be a bear put spread. In this case, the short put should be one strike below a support level for the stock.

This shows that time decay need not be the primary factor driving your choice between the two strategies. Rather, it depends on whether there are benefits in holding the stock such as bonus shares or cash dividends. If not, you should prefer the replacement strategy for two reasons. One, it is emotionally satisfying when you take profits on your long stock. And two, it reduces your risk exposure as the switch from the long stock to the long call reduces the invested capital.

The author offers training programmes for individuals to manage their personal investments

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