Options are one of the most frequently misinterpreted, maligned, and misunderstood pieces of modern financial history. While they can indeed be complex at times, let’s examine one very simple way to use them—the stock replacement strategy.
Stock replacement employs the inherent leverage in options to mimic the movement in price of an underlying security, while massively reducing overall capital risk. This usually involves purchasing a deep-in-the-money option, which will mitigate volatility risk and give the investor the highest possible delta. Delta is a measure of how the option reacts to the price movement in the underlying security.
For instance: A delta of 1.00 means that, for every $1.00 the stock move, the option will move $1.00 as well. Deep-in-the-money options usually have deltas close to or exactly 1.00.
Lets now take a look at ways to play a nominally high dollar stock, like Apple Inc., with a stock replacement strategy and how it affects overall risk:
If you wanted to be long the stock, you could purchase the January 2011 $240.00 call for roughly $71.60. The option has a delta of 0.99 and gives you participation in AAPL to the upside at a ratio of $0.99 for every $1.00 the stock moves. On the other hand, if AAPL were to suddenly fall to zero (think Enron here), you would only lose $7,160 instead of $30,974. Overall you decreased you capital risk by 76.8%, giving you the ability to walk away from the stock practically unscathed.
If you wanted to be short the stock, you could buy the January 2011 $390.00 put for a net debit of roughly $81.00. The delta on this option is currently -0.98, which indicates that for every $1.00 of movement higher this loses $0.98 and vice versa. If the stock was bought out at lets say $1,000 per share, you could only lose the $8,100 paid for the option instead of $69,042 you would lose if you owned 100 shares. That’s a capital risk reduction of 88.26%.
Options do not have to be complex and misunderstood instruments; with a little knowledge they can prove to be immensely helpful in reducing risk in your portfolio.
— Michael J. Zerinskas