Stock Replacement With Options (With 4 Scenarios)

I was looking for ways to protect your profits given possible volatility from the elections. To my surprise, there was an easy solution with call options, though it is not a 100% stock replacement given the delta is not 1 due to the time value you are buying (meaning stock will go up higher while your options don't earn as much).

Advantages of Stock Replacement Strategy

Without understanding options, you should understand that the replacement strategy is meant to protect against

  • Major Stock Market Crash with Limited Loss; and
  • Have Unlimited Upside (but much less than owning the stock outright).

Many people call options as speculative and I kind of agree but they give you more options as a trader.

The best way is to learn is to see the results options under various scenarios.

Example of Stock Replacement With Options

The below example assumed $0 in trading fees which is unrealistic but really negligible in reality during a volatile period.

Example: You own 300 shares of XYZ, currently priced near $58 per share of $17,400. Take these steps:

  1. Option 1 - Keep the stock
  2. Option 2 - Stock Replacement with Options Sell the stock, taking your cash out of the market of $17,400. Immediately (do not wait for a "better time") buy three call options. The strike price should be in the money. In this example, you will probably want to buy the 55-strike call. However, the 50-strike call remains a viable choice if you are willing to accept additional downside risk. Assume you paid $5 each for a $55 strike (intrinsic value of $3 in the money, $2 was in time money). $1500 spent in total since 300 options lots. Choose an expiration date that meets your needs. The more distant the expiration, the more you must pay for the call option. However, a later expiration date offers portfolio protection for additional time.
  3. Option 3 - This option is just for comparison of profit/loss taking half the amount stocks as a comparison vs options.

I came up with 4 simple scenarios and their impact on the stock owner vs the option owner at the end of the call options:-

Scenario 1: Sharp Dip and XYZ declines from $58 dollars to $48 (18% decline)

  • A stock owner lost $10/share on paper (18% decline) and have $14,400
  • An option owner lost the 3 call options (100% lost)  $15,900 (better)
  • A stock owner that sold 50% of stock already (150*58+150*48) $15,900 (better)

Scenario 2: Mild Dip and XYZ declines from $58 dollars to $54 

  • A stock owner lost $4/share on paper and have $16,200
  • An option owner lost the 3 call options (100% lost) $15,900
  • A stock owner that sold 50% of stock already (150*58+150*54) $16,800 (better)

Scenario 3: Mild Rise XYZ increased from $58 dollars to $62 

  • A stock owner gained $4/share on paper and have $18,600 (better)
  • An option owner only gained $2/share from the 3 call options since they cost $60 (17,400+600) $18,000
  • A stock owner that sold 50% of stock already (150*58+150*62) $18,000

Scenario 4: Sharp Rise XYZ increased from $58 dollars to $68 

  • A stock owner gained $10/share on paper and have $20,400 (better)
  • An option owner only gained $8/share the 3 call options (17,400+2,100) $19,500
  • A stock owner that sold 50% of stock already (150*58+150*68) $18,900

Conclusion

I am seriously thinking about implementing this replacement technique, especially during sudden dips (maybe not selling my stocks but buying call options instead of DCA stocks again)

  • a stock owner is better off 2 scenarios (mild and sharp rise, i.e. max upside among 3 options)
  • An option owner is best off in a sharp dip (in my scenario selling 50% of stock get the same result will but will be worse off as stock price dip further).
  • a stock owner that sells 50% of the share is better off only in mild dips

The most important thing is how much time value for how much protection/upside you are paying for your options. Remember that the moment your options expire (either into stocks or worthless), you lose your protection and upside potential.

FYI, this is not a new innovative way as it is well-covered in other sources too:

    • Stock Replacement Strategy Definition (investopedia.com) - Stock replacement is a trading strategy that involves replacing the purchase of stocks with the purchase of its deep in the money call options.
    • It's an Option: Increase Buying Power with Stock Replacement (tickertape.tdameritrade.com) - Want to participate in the potential upside of stock while using only a fraction of the buying power? Here's how to do it with a long-dated call option.
    • Stock Replacement Strategy: Reduce Risk, Maintain Upside (finance.yahoo.com) - Stock replacement strategies can be a good way to optimize a portfolio.
    • Four ways to protect your stock portfolio using options - MarketWatch (marketwatch.com) - Although most investors' primary goal is to earn profits, one constructive way of using options is to protect your stock portfolio from disasters. Here are...
    • Worried about volatility? Try this strategy: Trader (cnbc.com) - Stocks are now positive on the year, but if you're worried about holding onto your winners, CNBC contributor Dan Nathan has a clever strategy.
Author
Sky Hoon. Read Full Bio
Website Owner, Twitter-er
He has been trading since 2008. He started this blog to share the journey about option trading. He dabbled in stocks, bitcoin, ethereum (in Celsius Network), ETF (lazy Dollar Cost Averaging) and also built websites for fun. He used this as a platform to share my experiences and mistakes in trading, especially options which I just picked up.

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