What is a stock replacement strategy?
Stock replacement is a trading strategy that substitutes stock options for stocks. The initial cost is lower, but the holder can participate in the earnings of the underlying stock almost dollar for dollar, as the options are almost +1.00 delta.
- Stock replacement is an options strategy designed to replicate the exposure equivalent to one share, but with less capital tied up.
- Deep call options are suitable for use in a stock replacement strategy and should have a delta value close to 1.00.
- Using options in this way frees up capital that can be used to reduce risk by hedging or increase risk by leverage.
How a Stock Replacement Strategy Works
An investor or trader who wants to use options to capture the equivalent, or better, earnings in stocks while pinning less capital, will buy call option contracts that are very much on the money. This means that they will pay for an option contract that gains or loses value at a rate similar to the equivalent value of the shares.
Measuring how closely the value of an option follows the value of the underlying stock is known as the option’s delta value. Option contracts with a value of 1.00 will follow the share price per cent. These options are usually at least four or more strikes to the bottom of the money.
The primary goal of a stock replacement strategy is to participate in the earnings of a stock at a lower total cost. Because it uses less capital to get started, the investor has the option of freeing up capital for hedging or other investments or leveraging more shares. Therefore, the investor has the option of using the additional capital to reduce risk or accept more in anticipation of a 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 work 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 either very in the money or have strike prices well below the current price of the underlying. They also tend to have shorter expiration times.
The delta is a ratio that compares the change in the price of an asset with 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 price of the underlying stock increases by $ 1 per share, the option will increase by $ 0.65 per share, all other things being equal.
Therefore, the larger the delta, the more the option will move at the same rate as 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 with a price of $ 10 would go up $ 1 if its underlying stock, which is trading at $ 100, goes up $ 1. In this case, the stock made a move. 1% but the option made a 10% move.
Be aware that adding leverage creates a new set of risks, especially if the underlying asset falls in price. The percentage of losses can be large, although the losses are limited to the price paid for the options themselves.
Possession of options does not entitle the holder to any dividend paid. Only shareholders 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 are omitted). If the stock rose to $ 55 per share, the total value of the investment will increase by $ 500 to $ 5,500. That is a 10% profit.
Alternatively, the trader can buy one on the XYZ options contract with a strike price of $ 40 for $ 12. Since each contract controls 100 shares, the value of the options contract at the beginning is $ 1200.
If the option delta is .80, when the underlying stock rises $ 5, the option rises $ 4 to bring the contract value to $ 1,600 ($ 1,200 + ($ 4 * 100)). That’s a 33.3% gain or more than three times the return on owning the stock itself.