Stock Replacement Using Options
The stock replacement strategy is essentially exactly what the name suggests. It's a strategy that uses other financial instruments to effectively recreate the position of owning stocks. It has been used for by investors and traders for a very long time and in recent years it has become especially popular using options.
Using options for stock replacement is really quite simple, and it offers a couple of key benefits relating to leverage. There are also benefits relating to hedging, although this makes the strategy somewhat more complex. We have explained more about this strategy and the benefits of using it below.
- Using the Stock Replacement Strategy
- Benefits Related to Leverage
- Benefits Related to Hedging
Using the Stock Replacement Strategy
The basic idea of the stock replacement strategy using options is that instead of buying stock that you have highlighted as being a worthwhile investment, you buy calls with stock as the underlying security. The calls you buy should have a strike price that is significantly lower than the current trading price of the underlying security i.e. they should be deep in the money.
The reason you buy deep in the money calls is because they have a delta value of 1, or very close to 1. Delta value is one of the options greeks which can be used to measure how the price of options changes, and it's something you should be familiar with. Please read this page if you aren't.
A delta value of 1 means that the price of the deep in the money calls should move approximately in line with the price of the underlying security. Therefore owning these contracts is effectively recreating the position of owning the actual underlying stock. We highlight how this works in the below example.
- Company X stock is trading at $50 per share.
- Calls based on Company X stock with a strike of $30 are available at $21.
- Person A owns 100 shares (valued at a total of $5,000)
- Person B owns 100 of the calls (valued at a total of $2,100)
- If Company X stock moves to $55 per share, the calls would be worth approximately $26 each.
- In the above scenario, Person A’s investment would be worth $5,500, for an increase of $500. Person B’s investment would be worth $2,600, also an increase of $500.
- If Company X stock moves to $45 per share, the calls would be worth approximately $16 each.
- In the above scenario, Person A’s investment would be worth $4,500, for a decrease of $500. Person B’s investment would be worth $1,600, also a decrease of $500.
As you can see, the net effect in absolute terms of the price changes is approximately the same from owning the calls as it is from owning the shares. Person B has recreated the position of Person A without actually buying any of the stock.
It's also apparent from the above example that Person B has invested significantly less than Person A. This is one of the main advantages of the stock replacement strategy.
Benefits Related to Leverage
Using options as a stock replacement strategy helps to unlock the potential of leverage. As we pointed out in the example we provided above, Person B has spent less on their investment than Person A. They can still benefit at roughly the same rate from any increase in the price of Company X shares though.
The ability to make similar amounts of money with less investment is an obvious advantage, and it's a primary reason why many people are choosing to buy options as an alternative to the underlying security. You get the full benefit of any appreciation in the security, but have invested less. You have the potential to make a higher return relative to the amount invested.
Additionally to this, the maximum possible loss is reduced. If Company X stock dropped significantly in price, to $20 for example, then Person A would see a $3,000 drop in the value of their investment. The options bought by Person B would have little to no value with that price drop, but they would have only lost their initial investment of $2,100 as opposed to $3,000. If the share price dropped even further Person A would lose even more, but Person B would still be limited to a loss of $2,100.
If you like using simple strategies, then these advantages are really all you need to know about the stock replacement strategy. There are, however, further advantages too, but it gets a little more complicated if you wish to take advantage of them.
Benefits Related to Hedging
Another benefit of this strategy is that it can be used to hedge a position. This isn't something that we advise beginners or inexperienced traders and investors to attempt, but it may appeal to those with some decent experience behind them.
The basic principle is that you can use the money you effectively save by buying calls instead of the underlying stock to hedge against the possibility of the price of the stock falling or remaining the same. You can do this writing out of the money call options or short selling the underlying stock. Typically you would do the former if you wanted to hedge against a small drop or no move at all, and the latter if you wanted to hedge against a significant drop.
The exact way you implement these hedging techniques will depend on how much you want to spend to protect your position and what level of protection you desire. This requires some in depth thought and is why we only recommended that more experienced traders undertake this aspect of the strategy.
The benefits of the stock replacement strategy using options are relatively clear. Beginner investors can certainly use it as a simple alternative to buying shares if they want to reduce the maximum possible loss or take advantage of the power of leverage. It isn't without its downsides, because you can lose money if the share price doesn’t move at all and you don’t get the benefit of any dividends that are paid, but in the right circumstances it can very much be the best strategy to use.
For more experienced traders the ability to be able to hedge the position if circumstances change and choose to what extent the position is hedged can be very appealing.