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

  • IVolatility Tools: Advanced Options

    Perhaps the toughest part of trading options is figuring out what to do. For this we have advisors, seminars, newsletters and more. Yet, one tool that all investors need, but few utilize adequately, is data. This concept is parroted across the industry, but how does the average investor move from the desire to utilize data to the actual practice?

    By Levi Ioffe,

    • 2 comments
    • 430 views
  • A Global Equity Put Write Portfolio

    Many that sell equity market put options focus on the S&P 500 (SPX, XSP, SPY). Some will add small caps by selling puts on the Russell 2000 (RUT, IWM). An investor could also make their put selling strategy globally diversified by adding MSCI EAFE (EFA) and Emerging Markets (EEM).

    By Jesse,

    • 0 comments
    • 351 views
  • The Random Walk Hypothesis

    The “random walk hypothesis” (RWH) is one idea about how stock prices behave – but only one of many. It is a theory promoted in academia and believed in my many, but not so much by traders involved with handling real money. Theories aside, is the market truly random?

    By Michael C. Thomsett,

    • 0 comments
    • 369 views
  • How To Trade Options Successfully

    I’ve now been trading options for over a decade and been associated with Steady Options for seven years – hard to believe.  Over that period, I’ve learned quite a bit about option trading; how to improve, what not to do, and generally how the option markets work. I’m still learning.

    By cwelsh,

    • 3 comments
    • 688 views
  • January 2019 Performance Analysis

    No one likes losing money, and no one likes hearing "excuses". However, in an effort to be fully transparent, solicit feedback, and to improve our own performance, we're writing this article to do a further breakdown of the losses which our model portfolio incurred in January 2019. 

    By Kim,

    • 17 comments
    • 1,487 views
  • Island Clusters as Strong Reversals

    Options traders constantly seek the elusive reliable reversal signal. A few unusual but strong reversals are worth looking for, and their patterns reveal likely exceptional timing for opening or closing option trades. One example of this exceptionally strong signal is the island cluster (or, island reversal).

    By Michael C. Thomsett,

    • 0 comments
    • 445 views
  • What’s Wrong With Your 401(k)? (If anything)

    There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States.  Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.

    By cwelsh,

    • 0 comments
    • 528 views
  • Upcoming Decay of Options

    I am on the hunt for a short volatility position for three main reasons. First, the market’s wild swings have, for the time being at least, diminished. Second, option activity has dried up as my options barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction.

    By Jacob Mintz,

    • 0 comments
    • 628 views
  • The Scientific Process of Increasing Expected Returns

    For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

    By Jesse,

    • 0 comments
    • 1,083 views
  • Those Golden and Death Crosses

    The use of moving average (MA) for predicting future price behavior must be undertaken cautiously. MA is a lagging indicator, so the question must be: Can a lagging indicator provide guidance for the future? Yes. The use of two MA lines and how they interact is a reliable form of reversal indicator.

    By Michael C. Thomsett,

    • 0 comments
    • 733 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


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