Stock Replacement: Under-Utilized to the point of negligence

Published on: Apr 12 2013 by John Critchley

Do you own any stocks?  If you do, let me clue you in on a little known and massively under-utilized option strategy: Stock Replacement.   If you are looking for a cheaper way to play stocks then outright buying shares, using a deep In- the-Money (ITM) call strategy, otherwise know in the options world as Stock Replacement, may be for you.

What is the strategy?

Replacing a long equity position by the equivalent number of shares via Deep In- the- Money (ITM) options.

Deep In- the- Money (ITM) is kinda a subjective term, but I like to have the option be a .85-90 delta option. That’s just me; you might want to go deeper.  The problem with going too deep is that, of course, the real dollar amount can get very high and this negates some of the advantages of buying deep ITM calls versus buying outright stock.

 

Why Use?

I was talking to a friend who asked me about Bank of America ($BAC) which he purchased for around $17. Now, of course, the stock trades at around $12 per share.  He still, however was still drinking The BAC Kool Aid and wants to continue to own the shares.

My advice? Consider using options to reduce the risk of holding the shares.

Let’s say he owned 1,000 shares that cost him $17,000. It’s may be quite a long time, if ever, that the stock ever sees $17 again.

But even though the shares are only worth about $12,000, that’s still money one can use for other investments – and there’s always the risk ( anyone remember Lehman and Bear Stearns?), that the company goes out of business and my friend’s  underlying investment would be worth $0.

On the other hand, there is always that the chance that the stock may see $17. There is no way to tell.  Bank balance sheets are notoriously hard to decipher – BAC’s especially so.

The simple trade:

Instead of owning 1000 shares of BAC at $12.00 = $12,000, let’s buy 10 contracts of Jan 2014 10 calls at $2.50 = $2,500

Use the balance to invest in other places.  Sounds simple enough, no?  Yes, but for the sake of full disclosure, with every trading strategy there are always risks. Here are some more advantages and some disadvantages of buying deep In- the- Money options as a stock replacement:

Advantages

  1. Deep stock protection- no risk under 10. If the stock goes under $10, the options are worthless and my friend loses $2,500. However, that is all he can lose.  With straight underlying ownership, he theoretically is risking an additional $10.
  2. Higher delta to match stocks movement upward- if the stock rips higher, the options should move nearly one-for-one with the underlying.  
  3.  Control a stock with less money at risk vs. cash purchase for stock. 1000 shares of BAC at $12 = $12,000 or buying 10 contracts of Jan 2014 10 calls at $2.50 = $2,500.   That’s simple math.
  4.  Tax implications: Selling stock could mean recognizing a taxable gain – and option gains or losses can be taxed differently than stock (consult a tax advisor for details).
  5.  Synthetically owning high price underlyings for the fraction of the cost- of outright owning the shares.

Disadvantages

  1. Time decay can hurt option price as expiration nears. Remember you are paying some premium to own these calls. In this case, $.50 cents.  This is approximately the price of the puts.   Go back to the Synthetics BootCamp episode (click here)  as we explain the Calls are Puts and Puts are Calls theory of options pricing.
  2. There might be Wider Bid/Ask prices. Poor liquidity:  Be careful. As we have stated many times, if the market is wide put the bid or offer at mid-market and you may get executed. Never use market orders.
  3. Options do not pay dividends. No dividend: Owning call options doesn’t mean you’re a shareholder. You don’t receive any dividends and get no vote on shareholder issues.
  4. Residual Post-Expiration Ownership factors- If you don’t have enough money in your account to buy the stock when your contract expires then you have to sell before expiration. Also, if investors let contract expire then it will be exercised automatically.

Stay Tuned…………

 

Share this:
Share this page via Email Share this page via Stumble Upon Share this page via Digg this Share this page via Facebook Share this page via Twitter
Filed under: Trade News

One Comment to “Stock Replacement: Under-Utilized to the point of negligence”

  1. Bill Mason says:

    I like the idea of buying Options instead of stock, but in the example above (and this is my greatest Options fear), what if the Options expire worthless, I’m out $2,500 with nothing to show for it, not even stock that is losing its value… what should I do in that situation? $2,500 is a lot to me, and I assume I could do a lower price stock/option combo… now I know that any stock can get reduced to zero, but the idea of spending that amount of money and possibly ending up with nothing seems a little unsettling to me. I could be wrong, what do you think?

Sorry, the comment form is closed at this time.