Newbie to options, want to lock in stock gains

wakkus said: "Hey everyone... just some background: I'm a complete newbie at options, and am long term investor who is looking at options for a specific scenario. Here's my story: I currently have a position in a stock that I've held for about 9 months. It's appreciated about 35% during this time, including a big run-up during the last 2 days. Judging from my estimates of intrinsic value, I think the stock is now fairly valued to slightly overvalued. I would sell right away, the only problem is that I have to pay short term gains tax. Holding a few more months, if the stock price even declined a few percent, would make me *more* money, since I pay less in taxes. However, given my valuations of the company, I'm slightly worried that the stock will decline more than a few percent. If that happened, it would be smarter to sell now. Enter a modified version of a 'synthetic call' options strategy - I can buy Sept 07 $50.00 puts (the right to sell shares of the stock at the given price) which, combined with the outright shares that I have, puts a floor price ($50) on the minimum gains I can make. This is true because for any price that I would sell below $50 I would offset the gains from the call option with the loss in value of my actual shares. If the price is above $50 when I sell, the call option is worthless and my gains per outright share are deducted by the cost of the option, which is ~$2.00 a share. So, the question is, do I do it? As some background, I bought shares for $40 and they basically trade at $55 now. Making an assumption that I have an AGI of $32K this year, my tax liability on short term gains would be 25% federal + 6% state or 31%. My tax liability for a long term gain would then be 15% federal + 6% state or 21%. Therefore, selling my shares after a year at $53.10 would net me the same return as if I sold at $55 now. It seems like to me that if I were able to say, buy $55 calls for less than $1.90 ($55 - $53.10), I should definitely do it. However, they don't sell $55 calls right now. With the calls at $50, it brings more into the picture my fears of it being overvalued and it dropping to somewhere back in the high 40s. What do you think?"

drdan said: "First what is the stock symbol? Also if the stock is at or near $55 they would most definitely have puts and calls available to trade, so if you want to protect your profits at $55 you can buy a $55 put or sell a $55 call. If you are more concerned about protection then I would buy a put as insurance. And if you think the price is going to go down why would you want to buy a call right now? You should wait for a pull back just like if you were going to buy the stock."

wakkus said: "Thanks for the reply... the ticker is PRAA. Oops, I accidentally wrote call option near the end of the post - I definitely mean to buy puts. I'll go back and edit my original post... By the way, there are $55 December options as well, but of course they cost a lot more. How do I know when buying the put as an insurance is a good deal?"

drdan said: "Well Wakkus you are in a Catch 22 here. Options are priced pretty fairly here in recent years so its not like you are going to get a bargain for buying a put. Now in your situation, the problem is that not only has price spiked recently but so has volatility. With the spike in volatility the options are going to be higher priced, so it will cost more for the protection. So in answer to your last question...it depends on your risk tolerance and your opinion of insurance. In order to calculate out if you should do this - first you need to choose an option that is at least one month more than when you want to sell the stock. So you are correct in looking at least at the September Options which will cost less than the December options. Next look at the difference in cost between the $55 strike and the $50 strike. The $55 Strike ask is currently $3.80 and the $50 strike is $2.00 a $1.80 difference for a $5 spread sounds like the $55 is a bargain in comparisson. However with volatility high you are going to be paying extra premium and if volatility drops in the next 3 months so will the price of your option, even if the stock price decreases, which is why you are in a catch 22. You want to buy options at low volatility and sell options at high volatility. Also you forget that your option can be sold at anytime so lets say three months from now the stock stays around $55 or maybe goes a little higher your put is not going to be worthless it will be worth something and you just sell it back thus making the cost of the insurance cheaper. Anyway all things factored in, if you are trying to protect profits just because of taxes it is not worth it, like you said it is only a $1.90 per share difference. Protective puts are used more for major corrections in stocks that are going to be held for a long term or by the big boys that can not get in and out of trades that fast because they own so much stock. In my opinion for you a small trader that is going to close this trade out in 3 months should either just put a stop loss or sell calls off the stock and risk being called out if the stock rises above your sold strike price, or actually what I would do is both and not worry about the taxes. I should tell you a story about my father-in-law who blew a big gain on a penny stock because he did not want to sell because of taxes. He watched it go down from $12 back to $1.00 because he had not held it for a year. I told him to sell at $10 and just pay the extra tax, a profit is a profit who cares about the taxes, but he didn't and he wouldn't. BTW, he bought in at $.80, what a waste just because of taxes and he still holds it today because someday he thinks it will rise to that level again."

Rbreb13 said: ".80 to $12!!!!!! I'd pay taxes on a gain like that with a bigass smile on my face and be happy to do it as often as possible!"

wakkus said: "Hey drdan, you rock. Thanks for such a great reply! Even I can understand it, and that's saying something. I looked for a bit at the covered call strategy (selling calls) - it looks like it gets a little complicated though, especially since it doesn't limit my downside (only adjust my basis). If I'm contemplating a stop loss for a gain, I usually realize that I should just sell the thing. Your story about your father in law is exactly right - getting worked up over the short terms gains tax is madness if you've got a big gain on the table. So, I think after all of this, I'm just going to sell. The long term prospects for the business I'm realizing are too hard to call, and as I see it now from even liberal DCF, it's overvalued. Thanks again for all your help and insight!"

drdan said: "@ wakkus - glad to help @RbReb - You are not kidding! I got in at $5 and told him to sell my portion when it hit $10. He did not do that either. He was caught up in the hype and insisted that it was going move to a big list...It was going to hit $30 when it went to the big list. I remember that so clearly. I wanted in at $3 but when it opened at $3.50 that morning my father-in-law did not place the order, so that was my first clue that this was not going to be a good trade. It climbed to $5 by the next day and that is when I told him it was OK to buy (I was caught up in the hype as well), then a week later he was telling me that rumors were abound saying that it was going to $12 that week and the next stop was the big list. I told him well when it hits $10 sell my shares. "Why would you want to do that?" was his response. I told him a 100% gain is just fine for me thank you. "But you'll have to pay the taxes on that??? And you'll lose out on the gains when it goes to $30. You don't want to sell." Then my wife got involved and there went my 100% gain. The stock did hit $12 that week at it's peak for about 10 minutes then closed at around $9 or something like that that day. Did my shares get sold? NOPE It is my biggest I told you so ever. All because of hype and taxes. I mean even after we saw it start to plummet he could have sold it for $5 and still made a killing but no he would have to pay taxes on it.:signs053: I just checked today to see where it is at...the symbol has changed (couldn't find it at first) and it now sits at .285, but with the symbol change its poised for some hype again. Hopefully I can convince him to sell at the next hype up. Moral of the story - 1. Stay away from pinkies 2. Listen to your son-in-law if he knows more about trading stocks than you do. Oh and I can make you even sicker - he bought $8K worth at .80! That would have been around $100K gain if he had sold when I told him to and in only a couple of months. I still to this day do not understand why he did not sell. I guess, he truly believed it was going to go to a big list and he was going to be able to live off the gain for awhile selling off small amounts of shares here and there to supplement his income."