Using A Stock Replacement Strategy To Reduce Risk Without Limiting Upside
The last time we discussed using a stock replacement strategy was back in February when the “SPDR 500 (SPY)” was hitting an all-time high. With nothing but clear skies, no visible ‘overhead’ on the charts, and an economy seemingly firing on all cylinders, investors might have rightly viewed advice to temper their bullishness with skepticism.
But that environment and attitude seem worlds away, so I thought it would a good time to review the use of a Stock Replacement, with an emphasis on how it only reduces risk without limiting upside exposure.
A replacement strategy is essentially replacing ownership of shares with the purchase of call options. This is a good time to review the process and benefits.
Replace Rather than Remove
When people want to reduce risk but maintain upside exposure, they usually think in terms of buying put protection as a form of portfolio insurance. While this can be effective in minimizing losses during a decline, it can have a significant drag on performance in the form of the cost premium paid for put options.
An alternative approach is a stock replacement strategy in which one swaps owning shares of the underlying for being long call options. The two main advantages of a replacement strategy over a married put position are:
- It greatly reduces the capital requirements and provides the flexibility to redeploy cash in new investments or opportunistic fashion.
- It offers the benefit of the leverage of options to maintain greater upside potential on further gains.
Basic Replacement
My basic rules of thumb for implementing this are:
- Buy call options that have at least six months remaining until expiration. This will help reduce the negative impact of time decay (theta) in which premiums get eroded. I’m assuming anyone who has enjoyed the gains of the past year or two has a long-term mentality, so using LEAPs, or those options that have a year or more also makes sense.
- Choose a strike price that has a delta of at least 0.70. This will usually mean buying a call that is about 10% in-the-money. Let’s take a look at Apple (AAPL) which is set to report earnings after the close today.
The stock is currently trading at $245 a share. Calls with a $225 strike price have a delta of 0.72. This means that for every $1 move the value of the option will gain or lose) approximately $0.72. But remember, delta works on a slope, meaning that as the price rises and the call moves further into-the-money, the delta will increase to the point it approaches 1.0 meaning the position gets longer or more bullish as price rises. Conversely, if share price declines, so will the delta so the rate of losses decelerates.
In the example of above, one could buy the $225 call that expires June of 2020 for $1,700 a contract. This is a steep discount to the $24,500 it would take to buy 100 shares.
Now, assume shares gained just 10% to $270 over the next three months. The value of the call would be approximately $4,500 or a 75 % increase. This assumes no change in implied volatility but takes three months of theta into account which would equate to $1.05 of decay. The delta at that point would be 0.98 or essentially one-to-one correlation.
Obviously, the leverage of options greatly boosts the return, or losses, on investment on a percentage basis.
Calculating the Contracts
This brings me to an important point regarding determining the number of contracts one should buy. There are two basic approaches: delta-equivalent or share-count.
In the delta equivalent, if you own 1,000 shares and want to maintain the same exposure, you would need to buy 13 contracts of call with a current 0.72 delta. Be aware as price rises, your net exposure will increase up to a maximum of 1,300 share equivalent. In the Apple example, your total cost for 13 of the June $225 calls would be and risk is $36,000.
If you want to simply maintain a maximum 1,000 share equivalent, you would buy 10 contracts. Again, the current net exposure would be only 700 shares on a delta basis. In this case, your total cost and risk is $30,000.
These compare with the $245,000 it would cost to own 1,000 shares. Or assuming 50% margin, that’s still a hefty $65,000.
Of course, these are just basic examples and one could tailor a position to align with the specific risk profile and investment outlook. This could include more complex strategies such as spreads and combinations.
What you never want to do is use a dollar-equivalent approach. That is if you owned 1,000 shares of Apple, which currently has a national value of $150,000, you don’t want to buy $150,000 worth of calls. In our example above, that would be 110 contracts. Which makes your net long 11,100 shares or a 9,000 on a delta basis. Even if assumed 50% margin and cut those numbers in half, it is still an incredible increase in risk.
Drawbacks
Like anything in life, this comes with some comprise and potential pitfalls. Putting aside a mismanaging of position size, one must always remember that if the option falls out-of-the-money, there is the potential for 100% loss at expiration. In our example, that means if shares of Apple are below $225 on expiration, or just a 9% decline, the calls will be worthless.
Another consideration is unlike shareholders, owners of options do not qualify to collect dividends. Given that many of the past years’ best performers have been driven by a “bond equivalents” such as staples, utilities, REITs, and MLPs, this may be counter to the reason you already own the shares. And finally, selling a stock that has significant gains may have unwanted tax implications.
But for those sitting on shares with healthy profits that want to reduce risk, but maintain upside exposure, a stock replacement strategy makes sense.
Note: This article originally appeared at Option Sensei on May 6, 2020.
Category: Options Trading
