Suppose an investor wants to buy 100 shares of a stock. Let’s say it’s a high-priced stock trading at $109, for example. It would cost an investor just over $10,900 (100 shares x $109) plus transaction costs to acquire those 100 shares.
But what if I told you that a simple, risk-defined option strategy potentially allows investors to participate in virtually the same way as buying the stock, but for a fraction of the cost and with a fraction of the downside risk?
Intrigued? Excited? You should be. Because this simple strategy can potentially allow smaller accounts to participate in higher-priced stocks, and larger accounts to increase volume with decreased margin and defined risk.
Replacing Stock with Options
Stock replacement is a strategy where instead of buying a stock, an investor can buy a long-dated call option to “replace” the underlying stock. This strategy enables the investor to participate in the potential upside of a stock, but using only a fraction of the margin or buying power that would be required in an outright stock purchase.
For example, buying 100 shares of a $109 stock would cost just over $10,900. However, buying a January 2017 100 call option (with a 67 delta) would cost only $1,960 ($19.60 x 100) plus transaction costs. The $1,960 paid for one January 2017 100 call is about 82% less capital than the amount required to buy 100 shares of the stock.
Analyzing the Risks and Potential Rewards
The risk of the call is defined by the premium paid for the option plus transaction costs. Meanwhile, investors in the call have potentially unlimited upside, just as they would if they owned the stock, but with only a fraction of the downside risk.
One drawback to this strategy is if the stock pays a dividend, especially a relatively high dividend. The owner of a long-dated call option is not entitled to receive any stock dividends. Also, as with all long call strategies, there is a negative theta, or time decay, component that presents a risk.
Taking Stock Replacement to the Next Level
Now that you’ve learned how to replace buying a stock with a long-dated call option, let’s take it a step further and learn how to reduce the cost basis and theta risk of the long-dated call option. This can be achieved by selling a short-dated call option against the long-dated January 2017 call.
For example: an investor could sell an April 2016 115 call for $1.20 ($1.20 x 100) minus transaction costs. Now instead of having negative theta, the trade becomes a bullish diagonal spread. The risk profile of a bullish diagonal is similar to the covered call strategy. The bullish diagonal has positive theta decay and it reduces the cost basis of the long-dated call, all while working in the favor of an investor with a bullish posture.
Let’s break down some important factors pertaining to this risk-defined strategy. Considering the strike prices (100 long-dated call, 115 short-dated call) in this sample trade, it’s a bullish strategy with a target price equal to the strike of the short-dated call at 115 up until April expiration. There’s still downside exposure, but it’s a fraction of the risk compared to buying 100 shares of the stock.
Further, an investor could roll or close the short option prior to expiration, particularly if they think the stock might hold steady. In fact, investors could implement a rolling strategy, which could be used many more times based on the January 2017 expiration of the long-dated call.
To sum it all up, this is a defined-risk strategy to control overall cost basis while still maintaining a directional posture. The stock example we looked at is simply for illustration—this strategy is indifferent to underlying stocks.
I know this can be a lot to wrap your head around, especially if you’re new to options. That’s why I encourage you join us for Swim LessonsSM each day in the thinkorswim® platform at 10:30 a.m. CT. You can learn more about these and other strategies in a fun and interactive way.
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On the thinkorswim® platform, click Support/Chat > Seminars. There are also plenty of archived videos covering options, futures, and much more.