Keep More of Your Huge Gains with This Quick Trade

When most investors hear the phrase "hedging," they typically take an exasperated breath, roll their eyes, and think to themselves that it's far too complicated - but it's actually not.

Last week I covered a simple but very effective method to buy highly speculative biotech stocks ahead of critical announcements - and guarantee a safe exit price - even if the stock crashes as a result of poor trials results.

This week I want to expand on the same idea - but instead of focusing on establishing a new position, I want to focus on protecting hard-earned gains on big winners - specifically small-cap stocks ahead of earnings.

Small caps were on a tear in 2013, with the iShares Russell 2000 Index (ETF) (NYSE Arca: IWM) returning 36.81%, compared to SPDR S&P 500 ETF Trust (NYSE Arca: SPY), which returned 29.69% over the same time period.

That's great for investors targeting small caps like we do in Small-Cap Rocket Alert. Already in 2014 we've created three free trades after selling half our positions at 100% plus gains.

If you find yourself in the same enviable position, the next thing you'll want to consider is implementing a strategy to keep those gains from turning into losses - especially as the company comes up on such a potentially disruptive event as earnings...

When markets are running at new highs, like they are right now, it doesn't take much to get traders running for the exits to capture profits. This is especially true when it comes to small-cap stocks, which are typically considerably more volatile than their large-cap counterparts.

The same small-cap stock that has run up more than 100% in a few short months can see its share price cut by 20% to 30% in a single day if it misses, even modestly, when the company reports earnings.

Most investors will simply use a "stop" order as a means of protecting themselves from these kinds of events - but that type of order won't do you much good if the stock trades, in the afterhours, far below your stop.

In that case, the market will open and your shares will be sold at market, which could be well below the desired price you intended to sell your shares.

And seriously cut into your gains...

A much better way to protect yourself is to simply buy a near-dated put option with a strike price at which you would feel comfortable selling your shares. This strategy ensures you exit the position at the price you want (over the length of the contract) no matter what happens to the share's price.

Here's the best thing: If you're looking to hedge a position (using a put option) that has already run up considerably, the put options could actually be really cheap because most traders have lost sight of risk, and instead, are focusing solely on additional upside.  

Let's take a quick look at how this kind of trade might look...

Let say you purchased XYZ in December 2013 at $3.00 and now it's trading at $6.50, which represents a hefty 116% gain in less than three months. And, let's also assume the company is going to report earnings in the next few days.

[Just a quick side note regarding strategy: The first thing I would suggest is to sell half of the position once you've achieved at least a 100% gain. This effectively creates a free trade because you've captured (as a profit) the initial cost of the trade. Now it's time to move on to protecting your existing position ahead of the upcoming earnings report.]

With the stock trading at $6.50 I would consider purchasing "one" $6.00 put option (with the nearest expiration date "after" the date the company plans to report earnings) for every 100 shares of XYZ you own. This gives you the option (but not the obligation) to sell XYZ at $6.00 (on or before the expiration) no matter what happens to the price of XYZ shares after the company reports earnings.

As I explained in last week's article, I would like to see the put option cost no more than 5% of the strike price - but that's a personal matter. You might not have any restrictions on the price of the option. It is insurance, after all.

So in this case we would be looking at picking up the put option for about $0.30 per contract. If you're a numbers-cruncher like I am, you can simply add the $0.30 to your adjusted cost basis, which in this example would mean your adjusted cost basis for XYZ is now $3.30.

Adding to the overall cost basis of the position might rub some people the wrong way, but in this example the stock is trading at $6.50, so you're still sitting on a gain of 96.96%. Not too shabby, and you're protected!

With the position properly hedged you can now sit back and relax knowing that you can sell your shares on (or before) the expiration date for $6.00.

On the other hand, investors who don't have the put options are simply crossing their fingers hoping there won't be anything in the upcoming earnings to start traders stampeding for the exits. I don't know about you, but that doesn't sound like a very good way to protect your hard-earned gains.

After the company does report earnings, it's likely that one of three things will happen:

1) the stock pushes to new highs on good news,

2) the stock doesn't do much of anything because earnings were in line, or

3) the stock trades lower on earnings that didn't thrill the market.

In order, let's focus on what you would do next.

In the first scenario - the stock pushes to new highs on good news - there's nothing to do. Your shares are off and running, and you can just let the put option expire worthless - just like your monthly car insurance does at the end of every month. And like I mentioned in last week's article, at the end of every month you probably don't get too angry at the thought that you didn't actually crash your car in order to justify paying your car insurance. It's the same idea here.

The second and third scenarios - the stock doesn't do much of anything because earnings were in line, or the stock trades lower on earnings that didn't thrill the market - are where it starts to gets interesting.

If the stock ends up trading below the strike price just before expiration, you have a couple of options (pun absolutely intended). If you've decided you no longer want to own the stock, you can simply sell your shares at $6.00 (on or before the expiration) and lock in a handsome profit of nearly 82% (considering the adjusted cost basis on the position is now $3.30).

On the other hand, maybe you still want to own the stock. Remember, in this example, you actually hold the position for free as a result of selling half of the position for at least a 100% gain earlier.

Depending on how much the stock has pulled back, your options could be worth a lot more. If the stock has pulled back 15%, 20%, 25% or more, your options could easily be worth 100%, 200%, or even 300% more. At this point you could simply choose to sell your put options back into the market and bank a nice profit for your time.

If you're new to options, I invite you take a moment and read the The Power of Options to Slash Your Risk and Make You Money. If you're not a Money Map Report subscriber, you can click here to learn more.

So let's do a quick review....

When you're sitting on a big gain and you know there is a potentially disruptive event (like an earnings report) coming up on the horizon, you can very easily protect your gains, for very little cost.

And the best part about this strategy is that it allows you to hold on to hard-fought gains while at the same time leaving you open to major additional gains...