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What is a Stock Replacement Strategy?
Stock replacement is a trading strategy in which deep in the money call options are used in place of outright stock.
Although the initial price is lower, the bearer participates in the underlying stock’s gains almost dollar for dollar because the calls are nearly +1.00 delta.
Whether you support the Federal Reserve‘s unprecedented banking systems or not, there is no denying that they have increased equity prices.
The S&P 500 Index (^INX) is up 170 percent since the March 2009 low, 40 percent over the past two years, and 26 percent year-to-date.
A bull market that has lasted for so long and has experienced such low volatility is one that is among the largest, longest, and lowest volatility ever.
With the market at all-time highs and market multiples expanding back towards a “fairer” value of about 15.8x forward earnings in the face of muted growth, financial advisers and investors alike are growing worried about giving back these large returns or assuming too much market risk.
With the Fed not showing any signs of rushing to taper, let alone raise interest rates, another concern is that corporations will miss out on future gains.
At this point, there is no reason to believe that the market won’t continue to rise in the near future.
When investors seek to mitigate risk while maintaining upside exposure, they frequently consider purchasing put protection as a form of portfolio insurance.
While this can be beneficial in terms of mitigating losses during a decline, it can have a significant negative impact on performance due to the cost premium paid for put options.
An alternative approach is a replacement strategy in which one swaps shares of a stock for call options.
Using a replacement strategy instead of a married put strategy has the following two advantages:
1. A reduction in capital requirements, which offers the leeway to redeploy cash in new investments.
2. It brings the advantages of the leverage of options to preserve higher potential upside on further gains.
How a Stock Replacement Strategy Works
An investor or trader who wishes to use options to achieve the same, or greater, returns as stocks while committing less capital will purchase deep in the money call option contracts.
This means they will pay for an option contract that gains or loses value at a similar rate to the equivalent value of stock shares.
The delta value of an option is a metric that indicates how closely the value of the underlying shares tracks the value of the option.
Option contracts with a value of 1.00 will track the share price to the penny. Most of the time, these options are at least four strikes out of the money when they are first traded.
Another goal of this strategy is to benefit from stock gains while incurring less overall expense.
It allows investors to either free up capital for other investments or hedge their portfolio by purchasing more shares with borrowed money.
With the additional capital at their disposal, investors can reduce risk or increase it in anticipation of a higher potential reward.
Call Option Basics
Options are used by traders to get a small amount of the upside potential of the underlying assets for a low price.
However, not all options act in the same way. The higher the delta value of the options, the better for a stock replacement strategy.
There are a lot of delta-heavy options with strike prices well below the underlying’s current value. They also tend to have shorter times to expiration.
Using the delta, you can determine how much an asset’s price has changed in relation to the price change of its derivative.
The delta value of a stock option, for example, means that if the underlying stock’s price rises by $1 per share, the option’s price will rise by $0.65 per share, assuming all else is equal. This example shows how this works.
In other words, if you have a high delta, you will see your option move more in line with the stock.
Even if a delta of 1.00 were to be achieved, the ideal stock replacement would be created.
Special Considerations
Traders also use options for their leverage. An ideal scenario would see a $10 option with a delta of 1.00 rise by $1 if the underlying stock at $100 rose by the same amount. The stock only moved by 1%, but the option moved by 100% in this case.
You should be aware that adding leverage increases your exposure to risk, particularly in the case of an asset’s price decline.
Even though the losses are limited to the price paid for the options themselves, the percentages can be large.
Note: Ownership of options does not give the holder the right to any dividends that are paid. Dividends can only be collected by stockholders.
Stock Replacement Strategy
Assume a trader purchases 100 shares of XYZ at $50 each, for a total investment of $5,000. (Commissions omitted).
If the stock moved up to $55 per share, the total value of the investment rises by $500 to $5,500. That’s a 10 percent gain.
Trading XYZ options deep in the money with an expiration price of $40 for $12 is an alternative.
The initial value of the options contract is $1,200 because each contract controls 100 shares of stock.
Option delta of.80 means that when the underlying stock rises by $5, the option rises by $4, increasing the contract’s value to $1,600.
This represents a 33.3% gain, or more than 3 times the return on the stock itself.
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