As The Bulls Run Wild… Here Are Three Ways To Protect Your Profits

Like a dog getting out of the ocean, the market’s current reaction to bad news is to simply shake it off and run onto the next thing.

Dubai can’t pay its bills? No worries - the market immediately recoups its one-day losses.

Government spending set to increase even further to pay for healthcare reform and more troops in Afghanistan? The Dow tacks on another few hundred points.

Tiger Woods’ wife goes upside his head with a 5-iron? Tiger is the biggest celebrity endorser of Nike (NKE: 64.30 -0.37 -0.57%), yet the company’s shares remain unaffected.

Even weak companies have shuffled up to the trough and are getting fat… Take financial firm Zions Bancorp (ZION: 13.06 +0.47 +3.73%), for example, which has more than doubled since March. Same goes for shares of poorly run retailers like Sears Holdings Corp. (SHLD: 72.71 +0.50 +0.69%). Even Continental Airlines (CAL: 16.74 +0.82 +5.15%) and other beleaguered airlines, which are hemorrhaging money, have also posted 100%-plus gains from the lows.

The situation reminds me of the hobo fantasyland in Harry McClintock’s “Big Rock Candy Mountains” song. But instead of free hooch, food and handouts, the market is dishing out gains indiscriminately.

Here’s what you can do to participate in the upside, while also protecting yourself in case the party gets messy…

Will History Repeat Itself?

Every week, Investors Intelligence conducts a survey of advisory services. The last survey, taken on November 25, reported the highest level of bullishness in two years.

The survey’s results showed that 50.6% of advisory services were bullish, versus 17.6% that were bearish. There were 2.88 bulls for every bear. To put that in perspective, the 39-year average is 1.73 bulls for every bear.

The last time the reading was this high was October 17, 2007 - one week after the market topped out.

Back then, we were swimming along, aware of what dangers lay beneath the surface, but naively ignoring them. As long as we couldn’t see them, we couldn’t be hurt, many people thought.

Sound familiar?

Just two years later, after the housing and credit crisis reared their ugly heads and extracted many tons of flesh, it’s ludicrous to not at least acknowledge that we could be in for some trouble ahead.

Question is… How do you prepare for it?

Three Ways to Protect Gains and Grab Big Upside

Here are three ways to play defense and attack the market at the same time…

• Tighten Your Trailing-Stops

When you’ve got gains of 78% on one stock and 37% in another, you’d be foolish to let them evaporate. So in Wednesday’s weekly portfolio update that my colleague Karim Rahemtulla and I send to our Xcelerated Profits Report members, I did just that with my recommendations.

All you do to avoid a winner turning into a loser is simply raise the trailing-stop level to protect your gains. But you should have stops set on all your positions. As I’ve said before, this will enable you to sell your stocks without letting emotions get involved.

If you have winning positions in your portfolio, be sure to place your stop level at least at your entry price, so you won’t lose money. And if you already have stops in place that are pretty generous, you might want to consider tightening them up, particularly if the stocks are not especially volatile.

• Buy LEAP Options

LEAPS are options that have expiration dates of a year or more into the future. The great thing about LEAPS is that they allow you to control shares for a fraction of the price you’d pay if you bought the shares outright.

For example, let’s say you’re bullish on Apple (AAPL: 193.32 -3.16 -1.61%). At the current price, you’d have to shell out $19,700 (plus commissions) to buy 100 shares. Alternatively, you could buy a January 2011 call option with a strike price of $200 for $32.30. That means you can control those same 100 shares of AAPL for just $3,230 instead of $19,700.

The difference is that with the LEAPS, you only control those shares until January 2011, whereas if you buy the stock itself, you own them indefinitely. Just like a stock, if the price of AAPL rises, your LEAP options should, too. And if AAPL declines, so should your LEAPS.

My colleague Karim Rahemtulla is one of the best in the business at finding great LEAP options to play, so if you want a more in-depth rundown, check out this column.

• Sell Put Options

Selling puts is an excellent strategy when you’re looking to own a stock, but want to do so at a lower price than it’s currently trading. By selling put options on the stock at a certain strike price, you’re selling the right for someone to “put” (or sell) the stock to you at that pre-determined price.

Let’s say you like Amazon.com (AMZN: 137.58 -3.59 -2.54%), but at $145, you think it’s too expensive. However, you’d be willing to buy it for $130.

In this case, you could sell the July 2010 $130 puts for $13.20. That means you’d receive $1,320 in your account for the right to have 100 AMZN shares sold to you for $130 by July expiration.

If the shares remain above $130, it’s very unlikely that you’ll have to buy the shares and you simply keep the $1,360. But if AMZN shares dip to $130 or below, you may have the stock sold to you at $130. But remember, you’ve already collected $13.60 per share from selling the put option contract, reducing your buy price to $116.40.

Selling puts is an excellent way to invest in any market - but particularly one that’s overheated. It reduces your risk by only getting you in the stocks that you want if the price falls to your chosen level. It also generates income while you’re waiting.

Lee Lowell is the best I’ve ever seen at this strategy. In fact, he’s got a whole advisory service dedicated to it called the Instant Money Trader - and you can learn more about it here.

I suspect that at some point in the not too distant future, we’re going to see a sizeable market correction. But that doesn’t mean you should sit on the sidelines and watch it happen. You can be proactive - and the three strategies above will reduce your risk, while still letting you participate and giving you the opportunity to make money.