What is a Stock Replacement Strategy?
Stock replacement is a trading strategy that substitutes deep in the money call options for outright shares of stock. The initial cost is lower but the holder is able to participate in the gains of the underlying stock almost dollar for dollar since the calls are nearly +1.00 delta.
- Stock replacement is an options strategy designed to replicate the equivalent exposure to a stock, but tying up less capital.
- Deep in the money call options are suitable for use in a stock replacement strategy, and should have a delta value of close to 1.00.
- Using options in this way frees up capital that can be used to reduce risk through hedging or increase risk by leveraging.
How a Stock Replacement Strategy Works
An investor or trader who wants to use options to capture the equivalent, or better, gains in stocks while tying up less capital, will buy call option contracts that are deep in the money. 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 measurement of how closely an option's value tracks the value of the underlying shares is known as the delta value of the option. Option contracts with a value of 1.00 will track the share price to the penny. Such options are usually at least four or more strikes deep in the money.
The main goal of a stock replacement strategy is to participate in the gains of a stock with less overall cost. Because it uses less capital to begin, the investor has the choice to either free up capital for hedging or other investments or to leverage a greater number of shares. Thus, the investor has the choice to use the additional capital to either reduce risk or accept more in anticipation of greater potential gain.
Call Option Basics
Traders use options to gain exposure to the upside potential of the underlying assets for a fraction of the cost. However, not all options act in the same way. For a proper stock replacement strategy, it is important that the options have a high delta value. The options with the highest delta values are deep in the money, or have strike prices well below the current price of the underlying. They also tend to have shorter times to expiration.
The delta is a ratio comparing the change in the price of an asset to the corresponding change in the price of its derivative. For example, if a stock option has a delta value of 0.65, this means that if the underlying stock increases in price by $1 per share, the option on it will rise by $0.65 per share, all else being equal.
Therefore, the higher the delta, the more the option will move in lockstep with the underlying stock. Clearly, a delta of 1.00, which is not likely, would create the perfect stock replacement.
Traders also use options for their leverage. For example, in a perfect world, an option with a delta of 1.00 priced at $10 would move higher by $1 if its underlying stock, trading at $100, moves higher by $1. In this case, the stock made a 1% move but the option made a 10% move.
Keep in mind that incorporating leverage creates a new set of risks, especially if the underlying asset moves lower in price. The percentage losses can be large, even though losses are limited to the price paid for the options themselves.
Owning options does not entitle the holder to any dividends paid. Only holders of the stock can collect dividends.
Example of a Stock Replacement Strategy
Let's say a trader buys 100 shares of XYZ at $50 per share or $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% gain.
Alternatively, the trader can buy one deep in the money XYZ options contract with a strike price of $40 for $12. Since each contract controls 100 shares of stock, the value of the options contract at the start is $1,200.
If the delta of the option is .80, when the underlying stock moves up by $5, the option moves up by $4 to bring the value of the contract to $1,600 ($1,200 + ($4*100)). That's a gain of 33.3% or more than three times the return of owning the stock itself.