SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Stock Replacement Using Options


Stock replacement is an investment strategy that attempts to replicate the returns of a certain asset or group of assets by using a combination of different derivatives rather than buying the individual shares in the market.

This options investment strategy involves buying "Deep In The Money" (DITM) options to limit downside risk while retaining the full benefits of the stock. The options are purchased at a lower cost than the actual stock but still receive close to a $1 increase for every favorable $1 move in the underlying security which increases the percentage return for the same dollar move.

 

Advantages of stock replacement strategy:

  • Keeps all benefits associated with trading the stock.
  • Reduces costs associated with owning the stock.
  • Offers more leverage by increasing the potential percentage return.
  • Offers lower downside risk.

Disadvantages of a stock replacement strategy:

  • Needs good trading experience and skills to master the strategy.
  • The strategy may fail, when the stock stays on (almost) the same price or moves sidewise.
  • Leverage works both way - If the stock falls, the percentage loss is larger as well.

Let's check how you could use this options investment strategy to reduce your cost of owning Apple. The stock closed at $174 yesterday.

 

Experienced options traders are usually well aware of this strategy and make good use of it.

 

Strategy No. 1: Buy 100 shares of the stock

Buying 100 shares will cost you $17,400. Not cheap. If the stock rallies to $185, you have made $1,100 or 6%. Let's see how it compares with the stock replacement strategy.


Strategy No. 2: Buy DITM call

As an alternative to buying the stock, we can buy the AAPL July 20 2018 130 call at $45.47. The cost will be $4,547 which is about 26% of the cost of the 100 shares. The P/L graph looks like this:
 

image.png


If the stock rallies to $185, you have made $1,030. This is slightly less than buying the stock, but percentage wise, it is a 23% gain, compared to the 6% gain when owning the stock. Of course the opposite is true as well - if the stock goes down, your percentage loss is much higher. 

This is called leverage. It works both ways - you increase the reward if the stock rises and increase the risk if the stock falls.
 

However, if the stock falls, the volatility should increase which actually helps our option price because increased volatility can cause option prices to increase or not fall as fast. So basically even though we will gain $1 for every $1 the stock increases we will lose slightly less than $1 for every $1 the stock drops.
 

You might noticed that we gained only 93 cents for every $1 movement in the stock. This is due to the fact that the delta of the 130 call is 0.93. We could choose a call which is deeper in the money - it would have a higher delta and have a better replication of the stock movement. However, it would also be more expensive and provide less leverage. 0.90-0.95 delta provides a good compromise between 1:1 movement and a reasonable price.
 

Now let's see if we can do better.
 

Strategy No. 3: Buy DITM call and sell OTM call against it every month

Here is how it works:

  • Buy AAPL July 20 2018 130 call at $45.47
  • Sell AAPL Feb 16 2018 185 call at $1.55

We reduce the cost of our trade by $155 to $4,392, but we also limited our gains. The P/L graph looks like this:
 

image.png


As we can see, we increased the maximum gain to $1,147. This gain is not only larger than the dollar gain from owning the 100 shares of the stock, but also translates to a cool 26% in one month. If the stock is below $185 by February expiration, we can repeat the process with the March options. If it is higher, you just close the trade for a gain and can roll to higher strikes.

Of course if you believe that AAPL will be higher than $185 by Feb expiration, you will be better by just buying the DITM calls.
 

Strategy No. 4: Buy DITM call, sell OTM call and buy OTM put

Here is how it works:

  • Buy AAPL July 20 2018 130 call at $45.47
  • Sell AAPL Feb 16 2018 185 call at $1.55
  • Buy AAPL Feb 16 2018 165 put at $2.07

Our cost now is $4,599, still significantly lower than owning the stock. The P/L graph looks like this:

image.png

Our gain is now limited to "only" $900 (20%), BUT we also limited our loss to ~13% in case AAPL goes down after earnings. And if the stock really crashes, the position can actually produce some gains because at some point the long put will more than offset the losses from the long call.

This is a variation of collar, where we replace the long shares with DITM call. 

And this is the beauty of options. You have almost endless possibilities to structure your trade, based on your outlook and risk tolerance.
 

Before investing any money, please make sure you understand what you are doing. Good luck.

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Realistic Expectations: Using History as A Guide

    One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.

    By Jesse,

    • 0 comments
    • 68 views
  • CAPM As an Alternative Option Pricing Model

    Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.

    By Michael C. Thomsett,

    • 0 comments
    • 296 views
  • Option Payoff Probability

    Options traders must, naturally, be concerned with the likelihood of payoff for a strategy. Ironically, one of the most often cited statistics about profit and loss is simply incorrect. That statistic is captured in the headline of a story posted online “Trading Options: Data Shows That 75% or More of Options Expire Worthless.”

    By Michael C. Thomsett,

    • 0 comments
    • 387 views
  • The Minimum Effective Dose (MED) For Cash Flow Planning

    Financial planners can usually give generic advice that will be appropriate for the majority of Americans, and that’s the goal of this article. If we can get the fundamentals of cash-flow planning right (where to put your money after you earn it and pay your taxes and bills), we’re 80% of the way towards maximizing our financial situation.

    By Jesse,

    • 0 comments
    • 439 views
  • Are You Breaking Even? Or Losing?

    Among the good reasons to trade options is the need to meet or surpass your breakeven yield. This is the yield you need just to preserve your purchasing power; and it higher than most people think. In fact, most people relying on moderate to conservative yields from stocks, mutual funds, real estate and savings accounts might be earning well below this breakeven level.

    By Michael C. Thomsett,

    • 0 comments
    • 518 views
  • Buy When You Have the Money, Sell When You Need the Money

    Money can be quite an emotional topic for many of us. Emotions can enhance our experiences and relationships in many ways, but they can act as mental roadblocks especially when trying to make wise financial decisions. One of the most common emotional roadblocks I come across when working with individuals is an unwillingness to invest idle cash to meet long-term goals.

    By Jesse,

    • 0 comments
    • 1,020 views
  • Strategy Selection vs. Risk Management

    "A billion here, a billion there, and pretty soon you're talking about real money." Everett McKinley Dirksen. Let’s begin with the bottom line: When I talk to anyone about the concept of choosing an option strategy (or two) to adopt for trading, I stress that the strategy should have certain characteristics.

    By Mark Wolfinger,

    • 0 comments
    • 491 views
  • Blending Anchor Strategy

    Anchor and Leveraged Anchor investors frequently ask why the strategy only trades SPY and SPY options rather than individual stocks, other indexes or commodities. We avoid individual stocks because of tracking and divergence issues.

    By cwelsh,

    • 0 comments
    • 600 views
  • Fundamental Volatility and Stock Prices

    Every options trader must wonder whether any connection will be found between the company's fundamentals and stock prices (and in turn, option valuation as well). Because options are derived from stock price behavior, the analysis of stock movement is crucial to selecting options wisely; and that relies on volatility in the reported profit and loss over several years.

    By Michael C. Thomsett,

    • 0 comments
    • 604 views
  • Bullish Short Strangles

    A bullish short strangle sounds like a complicated strategy, but it’s really quite simple for those familiar with option terminology. A short put is combined with a short call to where the position starts with some amount of positive delta overall. This distinguishes itself from a delta neutral strangle, where both the short put and short call are sold at the same delta.

    By Jesse,

    • 5 comments
    • 989 views

  Report Article

We want to hear from you!


Hi,

You write:

Strategy No. 3: Buy DITM call and sell OTM call against it every month

Here is how it works:

  • Buy AAPL July 20 2018 130 call at $45.47
  • Sell AAPL Feb 16 2018 185 call at $1.55

...... And:

If the stock is below $185 by February expiration, we can repeat the process with the March options.

  1. If it is higher, you just close the trade for a gain and can roll to higher strikes. You mean close the whole position: sell the DITM call and buy the 185 call?
  2. Is this No.3 strategy better than going synthetically long the stock (near zero cost) and hedging buying an OTM put?

Thanks

Share this comment


Link to comment
Share on other sites

1. You can close the whole trade, or you can close the short call only and roll to higher strike and further expiration.

2. It will be a different P/L chart, so not necessarily better or worse. It will provide better protection if the stock goes down, but if it stays unchanged or goes up slightly, No.3 will be better.

Share this comment


Link to comment
Share on other sites

Hi,

Strategy No. 4: Buy DITM call, sell OTM call and buy OTM put

  • Buy AAPL July 20 2018 130 call at $45.47
  • Sell AAPL Feb 16 2018 185 call at $1.55
  • Buy AAPL Feb 16 2018 165 put at $2.07

is a variation of collar, where we replace the long shares with DITM call.

I have read somewhere this same strategy but the expiration of the protective long put was the same as the one for the DITM call. 

  1. For the expiration of the long put is it better july (like DITM call) or february (like short call)?
  2. if the stock drops and the long put goes some strikes ITM can we take some money off the table selling the long put and buying another one lower?
  3. Can i do point 2. no matter what the expiration of the long put is (point 1.)?

Thanks

Share this comment


Link to comment
Share on other sites

1. Put with shorter expiration will produce a better protection if the stock goes down, but you can use July as well.

2. Yes we could.

3. Yes.

 

This is pretty similar to how PureVolatility strategy is managed (just the direction is the opposite, so all puts are replaced with calls and vice versa)

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs