Options Can Help Investors Protect Profits on Hot Tech Stocks

The scorching technology stock rally of the last six weeks has given investors an early Christmas present.

But with tech share prices having risen so much and valuations getting stretched so far, some investors may be looking to protect their gains--so as not to end up with the investment equivalent of a lump of coal if current highfliers reverse course.

Investors can, of course, simply sell any stock they fear may drop. But the prospect of realizing huge taxable capital gains in the final weeks of the year is understandably unappealing.

An alternative is to use options to lock in profits. Buying a “put,” for example, caps the potential loss should a stock go into a free fall.

But be warned: Just as technology and Internet stocks have gotten pricey lately, so have options on those stocks.

“The volatility of these stocks is so huge that, while the concept of protecting gains is valid, it’s so expensive,” said Jim Bittman, a senior instructor at the Options Institute, an arm of the Chicago Board Options Exchange.

Options are contracts that give the buyer the right, but not the obligation, to buy or sell stocks at specified prices by specified dates. A put confers the right to sell at a certain price--known as the strike price--before a set expiration date.

A “call,” by contrast, gives the right to buy a stock at a certain price by a certain date.

The cost to buy an options contract can vary enormously depending on such factors as the volatility of the underlying stock and the time until the option expires.

For an investor seeking to lock in a large paper gain, the most basic strategy is to buy a put.

For example, imagine you were prescient enough to buy 100 shares of Yahoo at its recent low of $110 in early August. It closed Monday at $351.06. That means you’re sitting on a profit of $24,106, and the total value of your holding is $35,106.

You could buy the April $350 Yahoo put. Then, if the stock drops below $350 any time before the contract’s expiration on the third Friday in April, you could exercise the option to sell 100 shares of Yahoo at $350 a share. This option is said to be “at-the-money,” because the current price and strike price are roughly the same.

If the price of Yahoo stays the same or rises between now and the April put expiration, the contract would expire worthless.

The cost, or premium, of that Yahoo option was $54.38 a share at Monday’s close, excluding brokerage commissions. Each options contract covers 100 shares. So the cost of a single option is $5,438.

Looked at another way, the cost is 15.5% of the price of the stock: $54.38 divided by $351.06.

Contrast that with an April at-the-money put for a less volatile tech stock such as IBM, which closed Monday at $109.70. The April $110 put goes for $9.88, or $988 for each 100-share contract. That’s 9% of the value of the stock.

At-the-money puts for other highflying tech stocks are similarly expensive. An April at-the-money put for Sun Microsystems now goes for 13.5% of the price; one for Qualcomm costs 16%.

“Personally, I’d never pay that much money for protection,” said Jerry Wang, a market strategist at Schaeffer’s Investment Research in Cincinnati. “That’s like the old mobster movies where you’re paying for street protection. At some point, it’s just too much.”

A potentially slightly less expensive alternative to buying puts on a particular stock is to buy a put contract for a broad stock index.

Imagine that you have $50,000 invested across several Internet stocks. You could buy a put on the Interactive Week Internet index, which closed Monday at 540.82.

Because each contract covers 100 “shares,” buying a single Interactive Week index contract covers more than $54,000 of market value.

The April $540 put costs $70 a share, or $7,000. As a percentage of the overall contract, however, the cost is 13%--slightly less than the priciest options for many individual tech stocks.

The danger of hedging with an index is that it won’t match the performance of your stocks--a phenomenon known as tracking risk. Say you own five Internet stocks that fall a collective 25% between now and April, but the index holds steady. You’d be out of luck.

One way for a put investor to keep down the cost of a put option on an individual stock is to buy a contract with a lower strike price.

For Yahoo, for example, you might buy an April $300 put instead of the April $350. The cost of the April $300 is $32.25, or 9.2% of the stock’s current price. Of course, you would have protection only if the stock tumbled below $300.

For investors who decide that buying puts is too expensive, an alternative hedging method is to sell a call on a stock you own. This is known as writing a covered call.

This strategy gives another investor the right to buy shares from you at a certain price by a set date. In other words, you’re selling another investor the right to “call” the stock away from you.

The benefit of this strategy is that instead of paying a premium to buy a put, you collect a premium by selling the call. The amount you receive on that sale could offset any drop in the price of the stock.

But unlike a put, you’re not fully insured if the stock plunges. And if it keeps rising, your potential gain is limited because the stock would be called away from you.

Many experts advise selling “out-of-the-money” calls. That means the strike, or expiration, price of the option (the price at which it begins to be worth something) is higher than the current stock price.

For example, you might sell the April $400 Yahoo call. That would earn you $4,178. But if Yahoo surged beyond $400, the stock would be called away and you would not see any further profit.

Walter Hamilton can be reached at walter.hamilton@latimes.com.