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How Investors Can Use Replacement Strategy to Reduce Risk, Take Profits

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Here's how replacement strategy works, and the three basic rules of thumb for implementing it.

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With most major indices and many individual stocks, such as IBM (IBM), Apple (AAPL), and McDonald's (MCD), enjoying stellar gains at multi-year or all-time highs but with valuations still near historic lows, it is understandable that there is a growing tension among investors as to whether to take profits or stay in for further gains. By using a basic replacement strategy in which one swaps shares for buying call options, both objectives can be achieved.

Cheap Is Relative

The above-mentioned tension can be seen in the VIX and its related products. Most people might be looking at the VIX (which measures the implied volatility on 30 options of the S&P 500 Index), which is currently around 18, as low, given that we've coming out of three-year period that averaged 27 with multiple spikes above the 50 level. While this absolute level may seem low, to my eyes the VIX is about as expensive as it has been in over seven months. This is based on the fact that the 30-day historical volatility (HV), or actual price movement of the S&P, currently stands at just 8.5%, so a VIX at 18 is more than a whopping 100% premium. One month ago the premium of IV (implied volatility) over HV was a mere 10%. And as you go out in time on the VIX futures contracts the premium only increases. This suggests that people -- professional money managers and individuals alike -- are still concerned about a big market drop and have been buying put protection.

But this big premium is mostly confined to index products such as ETFs like Spyder Trust (SPY), Powershares QQQ Nasdaq (QQQ) or iShares Russell 2000 (IWM) as people are really looking for broad portfolio protection. In individual names such as IBM, McDonald's, and even Apple, despite the latter's recent run and reversal which caused 10-day HV to more than double, the premiums of implied volatility over the stocks' historical volatility have collapsed over the past two months. These, and many others, have seen IVs go from 40-80% premiums down to 5-10% premiums. Meaning options on individual stocks are cheap, making their purchase attractive as a way to gain market exposure.

Basic Replacement

A replacement strategy is pretty straightforward, and as its name suggests, is simply selling out existing long holdings in underlying shares and replacing them with the purchase of call options. My three basic rules of thumb for implementing this are:

1. Buy call options that have at least six months remaining until expiration. This will help reduce the negative impact of time decay (theta) in which premiums get eroded. I'm assuming anyone who has enjoyed the gains of the past year or two has a long-term mentality, so using LEAPs, or those options that have a year or more, also makes sense.

2. Choose a strike price that has a delta of least 0.75. This will usually mean buying a call that is about 10% in-the-money. For example, the IBM January 2013 calls at the $170 strike have a delta of 0.74. In buying an ITM strike you will enjoy most of any further upside appreciation, which will only increase as delta increases, and the return on investment on a percentage basis will be much greater thanks to the leverage of options.

3. Only buy the share or delta equivalent of your current holding, never the notional value. So if you had 1,000 shares of IBM, you could look at buying 10 of the January $170 calls on a share basis or 14 on a delta basis. Do not spend $190,000 to buy 6,120 of those calls. That would make you one of the largest stakeholders in Big Blue.

The advantage of replacing shares for calls is basically that you drastically reduce your capital commitment and exposure while maintaining nearly all the upside profit potential.

Drawbacks

Like anything in life, this comes with some comprise and potential pitfalls. Continuing with the IBM example, that $170 call with a January 2013 expiration is currently trading around $31, meaning it has about $10 of premium. That is $10 you would lose assuming the stock stood still, and also represents a 10% increase in price that would need to occur to realize a profit -- not an insignificant hurdle. Also, unlike shareholders, owners of options do not qualify to collect dividends. Given that many of the past year's best performers have been driven by a move to large caps that provide a yield, this may be counter to the reason you already own the shares. And finally, selling the stock may have tax implications.

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No positions in stocks mentioned.

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