The energy markets have experienced a sizeable run-up in recent months. And the past three weeks have brought particularly sizeable gains. For example, just two weeks ago, several major coal mining stocks reported earnings for the first quarter. In nearly every case, earnings totally blew away analysts’ estimates and the stocks soared; the two largest US mining firms I follow were up on average more than 30 percent in just three weeks.

While the long-term outlook for energy markets and energy-related stocks is undimmed, there are clearly pockets of extreme momentum in the group. As I’ve often repeated, all great bull markets experience pullbacks from time to time and after such a great run, the risk of such a pullback is clearly higher. And from talking to many investors this week at the Atlanta Wealth Expo I can tell you that many are looking for ways to hedge their downside risk. All investors are keen to protect their tremendous gains racked up during the past quarter.

There are several valid ways of protecting gains. I often suggest selling out of part of your winning positions after a big run. By selling, a half position in a big winner you can stay in the stock but take some cash off the table at favorable prices. Another strategy I recommend is what’s known as a trailing stop. Basically, stop orders are orders you leave with your broker to sell you out of a stock automatically if it breaks through a particular price level. If you keep moving a trailing stop order under your winners as they rise, you can lock in incremental gains over time.

Both strategies can be highly effective at protecting gains on big winners. But for investors comfortable buying options, there’s a third way. In this issue, I outline the general strategy with some guidelines so that investors can apply it to their own portfolios.

In illustrating this strategy I use Peabody Energy (NYSE: BTU) as an example. While this was a longstanding recommendation in The Energy Strategist, it’s no longer recommended as a buy in the portfolio. This example is for illustrative purposes only.

Jesse Livermore was perhaps the most famous stock trader of the early 20th century; he made and lost millions of dollars in his day. And, for the record, that was a lot of money 100 years ago. Livermore was most famously immortalized in Edwin Lefevre’s thinly veiled biography Reminiscences of a Stock Operator, probably one of the best and most helpful books on trading and investing ever written.

One of Livermore's trading rules was “Be Right and Sit Tight.” He also said this is one of the hardest lessons for any investor to learn. In other words, Livermore suggested jumping on board a major trend and then having the courage to hold on to make the really big gains.

Clearly, energy is just such a major trend. As I've outlined on numerous occasions, demand for oil and gas is booming while the world's ability to expand supplies and production is, at best, limited. The great commodity bull markets throughout history have lasted for at least 15 to 20 years--this current up-cycle has more than a few good years left in which to run.

But that doesn’t mean there won't be corrections. Long-term readers are well aware that we've seen three significant energy corrections during the past 12 months. Each pullback lasted between one and three months and resulted in prices 15 percent to 25 percent off the highs for most stocks in the group. Each pullback also represented an excellent buying opportunity as the group subsequently rallied to new highs. The important thing to remember is that no great bull market has been immune to such corrections. Even the Nasdaq in the 1990s and gold in the 1970s saw corrections of as much as 30 percent in the context of a longer-term trend higher.

These corrections make following Livermore's “Be Right and Sit Tight” rule difficult. All too often, investors panic and get shaken out of the market during these corrections, thereby missing out on the even greater returns to come. At the same time, investors are correct to want to protect their gains; after all, making big money on a stock only to watch it evaporate is a sad strategy indeed.

Many traders and investors look at the options market as an aggressive speculator’s casino. And options can certainly be used in that manner. But options can also be used as a protective mechanism for those looking to hedge against a pullback. The best way to illustrate is with an example.

Here's how the strategy works.

Assume you purchased 200 shares of Peabody Energy last fall when I first recommended the stock at a split-adjusted price of $42.16. That would have cost you $8,432; with the stock now trading just shy of $70 your 200 shares are worth $14,000, a gain of more than $5,500. Most likely, you’re anxious to protect that sizeable gain.

Meanwhile, the December 2006 $65 put options--these are put options with a strike price of $65 that expire in late December--are trading at roughly $6.50. This option gives you the right (but not the obligation) to sell Peabody at $65 a share at any time between now and late December. Options are traded in contracts covering 100 shares so each contract costs roughly $650 at this time. To cover your 200 shares, you could purchase two contracts for $1,300. Here are the three possible scenarios for the stock:

• Peabody stays near $70 for the next seven months. In this case, your puts would expire worthless and you'd be out the $1,300. However, you'd still own the stock and be sitting on a total profit of about $4,300 (your $5,500 profit plus the cost of the options).
  
• Peabody continues to rally, reaching $85 by December. Your options are now worthless and you're out the $1,300. That said, your 200 shares are now worth $17,000. Including the cost of your options, your profit would be $7,268.
  
• Peabody sees a correction of 30 percent and falls to $50. In this case, you're still showing a small profit, $1,600, on your 200 shares. Better yet, your two options contracts now have significant value. The options would be worth $1,500 each on expiration day ($65 strike minus $50 stock price multiplied by 200). Thus you'd have made a gain of $1,700 on the options ($3,000 minus $1,300 cost). Your combined profit on the stock and options would be $3,300 and you'd still own the Peabody stock.
  As you can see, by purchasing the Peabody options, you can protect the majority of your gains in the stock while allowing plenty of room for upside if the stock keeps rallying.

• If you don’t feel comfortable with this strategy, don’t execute the trade, or consider only using it to cover one of your stocks.
  
• If you aren't comfortable with the concept or idea of options, consider starting out small or just avoid the idea entirely.
  
• Do NOT buy the options unless you are also long the stock.
  
• Do NOT buy the options unless you’re showing at least a 20 percent gain in that stock.
  
• If you do make this trade, cancel all outstanding stop orders on the underlying stock.
  
• Buy one contract for every 100 shares of stock you own to fully cover your position.

© 2006 Elliott H. Gue
Editorial Archive

KCI Communications, Inc.
1750 Old Meadow Road, Suite 301
McLean, VA 22101
703-394-4931 phone  703-905-8100 fax  email