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


Investopedia defines a stock replacement as "an investment strategy that attempts to mimic 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

  • Revisiting Anchor Part 2

    Last month we posted some updates to the Anchor strategy that were obtained using an in-depth back testing of the strategy and variations of it using the ORATS Wheel software.  We adopted three conclusions last month:

    By cwelsh,

    • 0 comments
    • 53 views
  • Covered Calls –Does Rolling Forward Mean Higher Risk?

    Do you roll forward to avoid exercise? It seems like an obviously advantageous move. You avoid exercise and generate a net credit. What can go wrong? Actually, rolling incurs more risk, and every covered call writer needs to study the potential roll and compare the advantages of rolling versus closing and taking a loss or allowing exercise.

    By Michael C. Thomsett,

    • 0 comments
    • 326 views
  • Portfolio Protection Utilizing Calendar Spreads

    Calendar Spreads (including diagonals and ratios) can be a very effective method to “hedge” a portfolio. However, it is not without some complexities.Understanding the Theory and Methodology is important to achieve one’s intended result. In essence, one must understand the whys as well as the hows or they will continuously be faced trying to resolve dilemmas along the way.

    By Reel Ken,

    • 1 comment
    • 611 views
  • The Magic of Compounding, and the Tyranny of Taxes

    Today I want to talk about something that is often ignored, yet has a very large impact on the net performance of our trading and investing: Taxes. To illustrate the importance, I often like to point out both the power of compounding and the impact of taxes with a simple example.  

    By Jesse,

    • 0 comments
    • 185 views
  • How To Select The Best Options Broker

    Selecting the right broker is one of the most important things for options traders. It becomes even more important if you are an active trader and trade hundreds or thousands contracts every month. Select the wrong broker - and your chances to make money are going down dramatically.

    By Kim,

    • 4 comments
    • 632 views
  • Are Binary Options Smart Trades?

    Some ideas are simple at first glance but contain risks that might  not be entirely obvious. Binary options are an example. Some traders love them, just as some roulette players are attracted to the appeal of “red or black” as a 50/50 proposition(or close to it, a 47.4% chance of winning due to the ‘0’ and ‘00’ possibilities).

    By Michael C. Thomsett,

    • 0 comments
    • 420 views
  • Options Trading Matrix

    One of the greatest benefits to trading options is that you can make money in an up, down, or sideways market. For example: In a bull market you can buy calls, or purchase bull call spreads and bull risk reversals. In a bear market you can profit buying puts, bear put spreads and selling bear call spreads.

    By Jacob Mintz,

    • 0 comments
    • 536 views
  • Trading Earnings: The Myths and The Reality

    Nothing impacts stocks prices more than company earnings reports. There are many way to trade those earnings announcements. You can take a directional bet if you believe the stock will move (higher or lower). Or you can play it with some of the non directional strategies.

    By Kim,

    • 0 comments
    • 634 views
  • Delta Hedging Your Options Strategies

    All traders begin with an introduction to call and put options.  However, it's rare (apart from short puts) that an experienced trader would use these contracts by themselves. Instead, we primarily trade options spreads. There are many benefits to spreads. The variety of spreads are targeted to various market criteria and market environments.

    By Drew Hilleshiem,

    • 2 comments
    • 749 views
  • Allocating on Blind Faith

    Almost all passive investment strategies are based on the assumption that younger investors should hold more equities as a percentage of their total portfolio. Likewise, as they age and get closer to retirement, the allocation to fixed income assets should grow while equity holdings shrink.

    By Michael Lebowitz,

    • 0 comments
    • 605 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


Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs