Sorry!! The article you are trying to read is not available now.
HOT TAGS:  

Stock Replacement Strategy: Reduce Risk, Maintain Upside

Print comment Post Comments
STEVE SMITH TALKS OPTIONS
DailyFeed
Whether you are a proponent of the Federal Reserve's unprecedented monetary policies, there is no denying it has driven equity prices higher. The S&P 500 Index (INDEXSP:.INX) is up 170% since the March 2009 low, 40% over the past two years, and 26% year-to-date. There were just two pullbacks in excess of 10% during the 2009 to 2011 period and just one pullback in excess of 5% during the past 18 months, meaning we are in one of the one of the largest, longest, and lowest volatility bull markets ever.

So with the market at all-time highs, and market multiples having expanded back towards a more "fair" value of around 15.8x forward earnings in the face of muted growth, money managers and individual investors alike are growing concerned about giving back these big returns or assuming too much market risk. But with the Fed showing no indication that it is rushing to taper, let alone actually raise interest rates, and corporations enjoying record profit margins, another fear is the prospect of missing out on future gains. And right now, there is no indication the market can't keep marching steadily higher for the foreseeable future.

When people want to reduce risk but maintain upside exposure, they usually think in terms of buying put protection as a form of portfolio insurance. And while this can be effective in minimizing losses during a decline, it can have a significant drag on performance in the form of the cost premium paid for put options.

An alternative approach is a replacement strategy in which one swaps shares of a stock for call options. The two main advantages of a replacement strategy over a married put position are:

1. A reduction in capital requirements, which provides the flexibility to redeploy cash in new investments.
2. It offers the benefit of the leverage of options to maintain greater upside potential on further gains.

Basic Replacement


My basic rules of thumb for implementing this strategy 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) , which erodes premiums. 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.

As an example, let's take a look at 3M (NYSE:MMM), which has gained some 38% YTD and seems poised to just keep marching higher.

With shares at $132, the $125 strike has a delta of 0.74. This means that for every $1 move, the value of the option will gain or lose) approximately $0.74. But remember, delta works on a slope, meaning that as the price rises and the call moves further into-the-money, the delta will increase to the point it approaches 1.0, meaning the position gets longer or more bullish as price rises. Conversely, if the share price decline, so will the delta as the rate of losses decelerates.

In the example of above, one could buy the $125 call that expires July 2014 for $11 a contract. Assume shares gained 10% to $145 over the next three months, the value of the call would be approximately $20 for a 94% increase. This assumes no change in implied volatility but takes into account three months of theta, which would equate to $0.80 of decay. The delta at that point would be 0.98, or essentially a one-to-one correlation.

Obviously, the leverage of options greatly boosts gains or losses on a percentage basis.

Calculating the Contracts


There are two basic approaches to calculating the number of contracts one should buy: delta-equivalent or share count.

In the delta equivalent, if you own 1,000 shares and want to maintain the same exposure, you would need to buy 13 contracts of call with a current 0.75 delta.

Be aware thatas price rises, net exposure can ncrease up to a maximum of a 1,300-share equivalent.

If you want to simply maintain a maximum 1,000 share equivalent, you would buy 10 contracts. In this case, the current net exposure would be only 750 shares on a delta basis.

Of course, these are just basic examples and one could tailor a position to align with specific risk profile and investment outlook.This could include more complex strategies such as spreads and combinations.

But what you never want to do is use a dollar-equivalent approach. That is, if you owned 1,000 shares of 3M, which currently has a notional value of $132,000 you don't want to buy $132,000 worth of calls. In our example above, that would be 120 contracts, which make you net long 12,000 shares, or a 9,000 on a delta basis. Even if we assume 50% margin and cut those numbers in half, it is still an incredible increase in risk.


Drawbacks


Like anything in life, a stock replacement strategy comes with compromises and potential pitfalls. Putting aside a mismanaging of position size, one must always remember that if the option falls out-of-the-money, it will result in a 100% loss. In our example, that means if shares of 3M are below $125 at expiration (a mere 7% decline), the calls will be worthless.

There is also the issue of the premium paid for the call option, which is a function of time and implied volatility. By using an ITM option, we are buying an option that has intrinsic value, which reduces the impact of time decay. In our 3M example, the premium is $4 above intrinsic value, meaning the breakeven point is $136 a share at expiration.

Another consideration is that unlike shareholders, owners of options do not collect dividends. Given that many of the past year's best performers have been driven by "bond equivalent" sectors such as staples, utilities, REITs and MLPs, this may be counter to the reason you already own the shares.

And finally, selling the stock that have significant gains may have unwanted tax implications.
But for those sitting on shares with healthy profits that want to reduce risk but maintain upside exposure a stock replacement strategy makes sense.

For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.

POSITION:  No positions in stocks mentioned.
TICKERS:  NYSE:MMM, NYSE:^GSPC   

TICKERS