Case study: Smartly reducing your investment while maintaining market exposure

Challenge:

Alex's NVIDIA shares have appreciated significantly, and he's looking to realize some of these gains. However, he wants to maintain his market exposure to NVIDIA due to its potential for further growth.

Solution: Using a long-term call option:

To achieve his goals, Alex decides to buy a long-term call option on NVIDIA. This option will allow him to buy NVIDIA shares at a set price of $850 each anytime until the option expires in June 2025, regardless of how high the stock price goes. This option costs him $20,300 for one contract, which covers 100 shares.

Portfolio overview:

Here is a breakdown of Alex's current portfolio before any transactions:

• NVIDIA (nvda): 100 shares at a buy price of $496, now valued at $847.2 each, totaling $84,720.
• Other holdings: Includes stocks like PayPal (pypl), Nike (nke), and Palantir (pltr), with various performances and allocations within the portfolio.

Financial mechanics simplified:

• Current stock position: Alex holds 100 shares of NVIDIA.
• Option purchase: The call option has a cost of $20,300 and provides similar market exposure to owning approximately 66 shares of NVIDIA.

How many shares can Alex sell?

By purchasing the call option, Alex can sell about 66 shares of NVIDIA without reducing his effective market exposure to NVIDIA's future price movements. This is because the option helps maintain a similar level of investment influence as the shares he plans to sell. Specifically, the call option has a delta of 0.66, which means that one contract of the option (covering 100 shares) effectively corresponds to the exposure of owning 66 shares of the stock (0.66 * 100 = 66). 

Benefits:

• Reduced direct investment: Alex can reduce his direct exposure by selling 66 shares, which would secure approximately $56,000 (66 shares × $847.20/share). After accounting for the cost of the option ($20,300), the net amount secured is about $35,700. This allows him to use these funds for other investment opportunities or to diversify his portfolio further.
• Maintained market exposure: The long-term option ensures that Alex still benefits from potential price increases in NVIDIA's stock.
• Flexibility and security: This strategy allows Alex to lock in profits while keeping the flexibility to participate in future growth, providing a balanced approach to managing his successful investment.

Risks:

While using long-term options can offer significant advantages, there are inherent risks to consider:

• Premium cost: The initial cost of the option ($20,300) is a sunk cost, meaning it is not recoverable if the option expires worthless. This represents a fixed loss if NVIDIA's stock price does not perform as expected.
• Volatility and time decay: Options are sensitive to changes in market volatility and lose value over time as they approach expiration — a phenomenon known as time decay. If NVIDIA's stock price remains below the strike price as the expiration date nears, the value of the option could decrease significantly.

Conclusion:

This approach allows Alex to capitalize on his gains in a high-performing stock while strategically maintaining his position for future growth. By using a long-term call option, Alex smartly adjusts his portfolio to reduce risk and secure profits, demonstrating a prudent method of portfolio management in a rising market. However, it's essential for Alex to consider the risks associated with options trading and monitor his investments accordingly.