Stock Replacement Strategy

Stock replacement is a trading strategy that substitutes deep in the money call options for outright shares of stock. The initial cost is lower but the holder is able to participate in the gains of the underlying stock, almost dollar for dollar.

The main goal of a stock replacement strategy is to participate in the gains of a stock with less overall risk. It uses less capital to begin and that frees up funds for any needed hedging.

Traders use options to gain exposure to the upside potential of the underlying assets for a fraction of the cost. However, not all options act in the same way. For a proper stock replacement strategy, it is important that the options have a high delta value. The options with the highest delta values are deep in the money, or have strike prices well below the current price of the underlying. They also tend to have shorter times to expiration.

The delta is a ratio comparing the change in the price of an asset to the corresponding change in the price of its derivative. For example, if a stock option has a delta value of 0.65, this means that if the underlying stock increases in price by $1 per share, the option on it will rise by $0.65 per share, all else being equal.

Therefore, the higher the delta, the more the option will move in lockstep with the underlying stock. Clearly, a delta of 1.00, which is not likely, would create the perfect stock replacement.

In a nutshell, the total value of high delta options is mostly intrinsic value and very little time value.

Traders also use options for their leverage. For example, in a perfect world, an option with a delta of 1.00 priced at $10 would move higher by $1 if its underlying stock, trading at $100, moves higher by $1. The stock made a 1% move but the option made a 10% move.

Keep in mind that incorporating leverage creates a new set of risks, especially if the underlying asset moves lower in price. The percentage losses can be large, even though losses are limited to the price paid for the options themselves.

Also, and this is critical, owning options does not entitle the holder to any dividends paid. Only holders of the stock can collect dividends.

Let's say a trader buys 100 shares of XYZ at $50 per share or $5000 (commissions omitted). If the stock moved up to $55 per share, the total value of the investment rises by $500 to $5500. That a 10% gain.

Alternatively, the trader can buy 1 deep in the money XYZ options contract with a strike price of $40 for $12. Since each contract controls 100 shares of stock, the value of the options contract at the start is $1200.

If the delta of the option is .80, when the underlying stock moves up by $5, the option moves up by $4 to bring the value of the contract to $1600 ($1200 + ($4*100)). That's a gain of 33.3% or more than three times the return of owing the stock itself.