How to Protect Your Market Rebound Profits

You watched in horror while that stock you own dropped over 30%. The relief you feel now after it recovered is outweighed by the dread of watching it sink again.

Or, you followed the adage to buy when there is blood in the streets and bought at the market low in March and neither want to squander the unrealized gain nor miss future gains if the stock continues upward.

Fortunately, you have some options.

Stop orders

Your simplest choice is to enter a good-til-canceled stop limit order or trailing stop limit order. With a stop limit order you set the price at which a sell limit order is triggered.

A trailing stop limit order sets the stop a set amount below the stock price high. As the stock rises, so does the stop at which the sell limit order would trigger.

A good approach is to use a support level for the stop. Support on a stock chart is where a pullback in an uptrend bottomed out. The rationale is that at the pullback low, buyers came back in and supported that stock price. Setting the stop below the support level would allow you to see if the support price brings in buyers again. If not, failure of support is a breakdown which normally portends further losses making it a good exit point.

Stop orders set the maximum loss from current levels that you are willing to accept before selling the stock. Using a good-til-canceled order allows you to unemotionally plan your exit strategy.

A key point is to use a stop limit order and not just a stop order. The limit sets the minimum price below the stop at which you are willing to sell. That would prevent an unhappy surprise should the stock gap down below your stop at the market open or another flash crash like the one in 2010 clears out reasonable bids from the order book.

Option strategies

Another downside protection strategy is to buy put options to cover your position. Buying puts gives you the option to sell the stock at the put strike price.

For example, if the stock is at $100, you could buy one put option contract for each 100 shares you own with a $90 strike price to limit the downside to $10. If the stock dropped below $90, you could exercise the option and sell the shares for $90 or you could sell the put for the difference between the current price and the strike.

If the stock price were at $80, each put would be worth $10 at expiration. The net value of your stock and put position would be $90, and you could then decide what to do with the stock.

There is a cost for the option, of course. The premium you pay depends on how far in the future the option expires and how far above or below the current price the strike price is.

The out-of-the-money put in this example would be less expensive than a put at the current price. If you exercised the put, your net proceeds would be $90 minus the premium paid for the put.

How far in the future to set the expiration depends on how much you are willing to pay for the premium and for how long you expect market uncertainty to continue.

Lastly, you could just sell the stock. To participate in potential upside, you could buy a call option which gives you the option to buy the stock at the strike price.

Back to the same example, if you were willing to lose the $10 during the drop to $90, you could instead use that $10 to pay the premiums for the call options.

If the stock rises, you participate in the gain less the premium paid. If the stock falls, your only loss is the premium paid for the call which should be much less than the loss in the stock price.

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