Stock Replacement with Long Calls

Published on: Sep 07 2016 by John Critchley

 

Stock Replacement with Long Calls 

 

By:  John J. Critchley, Jr.

Senior Option Specialist/Option Principal

 

Do you own any stocks?  If you do, let me show you a little known and massively under-utilized option strategy: Stock Replacement with Long Calls.   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 known 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 a subjective term, but I like to have the option be a .85-.90 delta option. You can view the delta of the option on the Chain page on the SogoOptions platform. The reason I don’t normally go deeper and aim to purchase a 1.00 delta option is that 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?

 

 

Let’s look at a beaten up bank stock like Barclays Bank ($BCS).  The stock trades at around $9 per share and is significantly off its all-time highs.   If you were an investor who bought BCS at a higher price and wanted to continue to own the shares, what should you do?

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

Let’s say we owned 1,000 shares that cost us $25,000. It’s may be quite a long time before that the stock ever sees $25 again.

But even though the shares are only worth about $9,000, 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 the  underlying investment would be worth $0.

On the other hand, there is always that the chance that the stock may see $25. There is no way to tell.  Bank balance sheets are notoriously hard to decipher – foreign banks especially so.

 

 

The simple trade:

Instead of owning 1000 shares of BCS at $9.00 = $9,000, let’s buy 10 contracts of Jan 2018  7 strike calls at $2.5 = $2,500.

 

Use the balance to invest in other places.  However, 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 7. If the stock goes under $10, the options are worthless and we lose $2,500. However, that is all we can lose.  With straight underlying ownership, we theoretically are risking an additional $9.
  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 BCS at $9 = $9,000 or buying 10 contracts of Jan 2018 7 calls at $2.50 = $2,500.
  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…………

 

 

 

Disclaimer


We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options.

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

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