One of the most difficult investment decisions can be when to sell a winning position.  While common wisdom is to let your winners continue to run, and cut losers quickly; there comes a time when even strong stocks need to be sold or paired back.  In the ZachStocks Growth Model, we have reduced several of our strongest positions in order to lock in gains and take some of the risk off the table.

Investors in Buffalo Wild Wings (BWLD) will have plenty to think about today as they wait for the company to announce earnings after the close.  Anyone who has purchased the stock in the last 6 months is now sitting on an outsized gain.  After all, the stock has risen from a low of $14.50 in late November to its current price above $42.  That’s a gain of 190% in just over 5 months!

When the stock was at its low in December, the market was discounting a severe slump in consumer spending, and vast uncertainty surrounding the state of our financial sector and the broader economy.  But at $14.50, it could be quite obvious to a rational investor that this stock was a great value.  In February when the company announced strong earnings, the stock shot up 34% in one day as investors breathed a sigh of relief.  The company announced that sales continued to grow with $121.2 million in revenue in Q4 and earnings of 43 cents (up 26% from Q4 of 2007).  This kind of growth hardly reflects a recessionary environment.

But today as we head into the earnings report, the mood of shareholders is quite different.  Buyers have bid up the stock to a point where it is trading for 25 times the expectations for this year’s earnings.  Hope springs eternal, and investors are apparently quite comfortable holding the stock of this strong growth company.  But if the trader’s goal is to buy fear and sell confidence, then it may be time to consider selling ahead of what could be a disappointing earnings report.

Now I understand that BWLD is a strong company with healthy cash flows and a loyal customer base.  I also understand that earnings are stable and growing when many competitors are faltering.  But I think that the stock price more than adequately represents these positive characteristics, but may have gotten a bit too high.  So today I want to discuss a way to capitalize on investors optimism while limiting the risk of a pure short sale.

In my years of hedge fund trading, we have always looked for ways to capture profits while limiting the amount of risk to our current capital base (that’s right, some hedge funds actually care about risk).  One of my favorite opportunities is to sell options with high premiums ahead of a scheduled event.  Once the event occurs, the price on those options typically declines substantially, and so our strategy acts as a buffer for the risk we are taking in the stock.  Let me give you the basic trade for BWLD and then explain how it works.  (prices may be different depending on market movements)

• Sell the BWLD May 45 calls (BQU EI) at $2.20
• Sell the BWLD May 40 puts (BQU QH) at $2.50
• Sell Short BWLD stock at $42.00

Now essentially this is a short play on BWLD with a bit of a hedge built in.  We are selling options and bringing in $4.70 per share in premium.  As long as the stock stays between $40 and $45 until expiration which is May 15th, that $4.70 is ours to keep.  The $4.70 helps to hedge our exposure to the short stock.

If BWLD trades down below $40, then we get to keep the $4.70 but are obligated to buy the stock at $40.00 when the puts are exercised.  That’s ok with me because I am short BWLD and buying the stock back at $40 would give me an extra $2.00 of profit for a total of $6.70 in profits.

If we’re wrong and BWLD trades up to $45 at the time of expiration, we still get to keep the $4.70 in option premium but we lose $3.00 per share on our short position.  So that leaves us with a two week profit of $1.70 per share, still not too shabby.

The risk comes in if the stock trades above $45.85.  At this point, our short BWLD position is off by $3.85 and we’re also obligated to sell stock to the owner of the calls we sold – giving us a loss of another $0.85.  Above this level we begin to accumulate losses.  My intention at this point would be to buy in my short position, and then buy enough stock to cover my calls as well.  That way when I’m obligated to sell stock at expiration, I already have the stock in my account.  But the risk here is still better than if you were to short BWLD as a simple short trade.

Now in order to sell options “naked” or without stock to cover the position, you have to have a margin account, and enough capital to cover the risk of the trade.  In order to place this trade you should also have a firm understanding of how each part of the trade actually works.  But for those who are willing to do some homework and think outside of the box, this type of trade can be quite lucrative.

If you’re interested in looking at alternative ways to approach market trading, then please give me a call and we can discuss what options are available to you.  My direct line is 678-467-7064 or you can email me at growth@zachstocks.com

FD: Author does not have a position in BWLD
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