Wednesday, August 29, 2012

Protecting Your Sirius Profits With $2.50 Puts

With Sirius XM (SIRI) reaching near 4 year highs at a close of $2.40 on Monday, many investors are wondering how far the current bullish run will take them.

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But that is not the only question on investors' minds. Also important for every investor is protecting your gains. Some may suggest locking in profits by selling partial or full positions. A great idea at the top, but who knows where the top is? For all anyone knows, we could be over $2.75 next week.

For that matter, for all anyone knows, we could be at $2.20, and this is where being a bit conservative and protecting and insuring your assets, comes in. And that is the concern. How do you lock in your profits on your position, retain the ability to benefit from the share price increasing, and cover yourself on the downside?

You buy option contracts called "puts."

The strategy I am about to outline is a very important one for Sirius XM longs to consider as we approach, and hopefully pass, the $2.50 price point. Once this share price is passed by a few cents, near term $2.50 puts should cost only a few cents to purchase, and become an excellent option for locking in your gains at relatively low cost.

First, an explanation of what a "put" contract is. A put contract gives the buyer the option to sell the underlying security (in this case Sirius XM) at the strike price (in this case, $2.50), any time before the expiration date (for this example, April 21). Contracts are sold in lots of 100, so when you purchase 1 put contract, this will cover 100 shares you own.

For this example I will assume the share price has reached $2.60, and the cost of one put contract is $0.04 (it will be up to you to figure in fees for your respective trading platform). Our owner of the shares is named Bob and he owns the following :

  • 25,000 shares of Sirius XM
  • Going share price of $2.60
  • Total value of $65,000.

Bob wishes to protect himself in the case of a retrace in the share price back past $2.50. To do this, Bob can purchase put contracts.

Because Bob owns 25,000 shares, to fully cover his position Bob must buy 250 put contracts. 25,000 / 100 per contract. Prices on the put contracts are $0.04 each, but since each one covers 100 shares, the price per contract is $4. Bob must spend $1000, which is $4 X 250 contracts, in order to cover his position.

So why did Bob do this?

If the share price drops below $2.50 by April 21st, Bob may sell his shares for $2.50 to the person who sold him the options. Consider, if the share price drops to $2.20, Bob can sell out his position for $62,500, or 25,000 X $2.50, instead of the $55,000 they would be worth on the open market. Bob just saved himself $7,500 because of his $1,000 option purchase and is thus $6,500 ahead of where he would be if he did not purchase the options. Bob may also keep his shares at this point if he wishes, and merely sell the option contracts back into the market for $0.30 each, or $7,500, if he wishes to keep his shares.

If the share price runs to $3 by April 21st, Bob's options expire worthless and Bob loses that $1000 he paid for the option contracts. But in this case Bob's shares are worth $75,000, so he has locked in a $9,000 profit.

If the share price stays stagnant at $2.60, Bob's shares retain the same value, but he loses the $1000 paid for the option contracts which expire worthless.

There are two break even points that are important for the option trader to make note of. Take the price of the put contract which is $0.04 in this example. Bob's break even points are $2.46 which is the strike price of the put, minus the cost of the put, and $2.64, which is the underlying share price at the time Bob bought the option contract plus the cost of the put contract. At these share prices, Bob breaks even.

Options can be looked at in much greater detail, but that would take pages of analysis to explain. Hopefully this article gives the reader a good idea of how to protect your recent gains in Sirius XM with put contracts, while still allowing for large gains to the upside. I believe the $2.50 puts will offer tremendous value as insurance if the share price passes the $2.50 strike very soon. Long holders would do well to consider them to protect against a possible retrace, and lock in these wonderful gains we are currently seeing.

Disclosure: I am long SIRI.

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