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It is clear from its name; Stock Replacement Options Strategy is a strategy that effectively recreates the position of owning stocks by using other financial instruments. It has become prevalent using options and has been used by investors and traders for a very long time and in recent years.
It is pretty simple to use a stock replacement options strategy. It offers benefits relating to the leverage provided by derivatives at a lower cost than that incurred from buying actual assets. Stock replacement options strategy aims to participate in the gains of stock with less overall cost.
Understanding the Stock Replacement Options Strategy
Investors or traders usually buy call option contracts deep in the money when they want to use options to earn the equivalent, or better, gains in underlying stocks while tying up less capital. Deep in the money call options are options contracts with an exercise or strike price significantly below the underlying price. They pay for an option contract that has gained or lost in value at a similar rate to the equivalent value of shares.
The reason behind buying deep in the money calls is that they have a delta value of 1, or very close to 1, which means that the price of these calls moves roughly with the price of the underlying security and effectively recreates the position of owning the actual underlying stock.
Understanding Stock Replacement Options Strategy with Example
For the purpose of understanding, let’s assume a trader buys 100 shares of Microsoft Corporation (NASDAQ: MSFT) at $240 per share. If the stock moved up to $264 per share, the total value of the investment rises by $2,400 That’s a 10% gain.
On the contrary, the trader can buy one deep in the money Microsoft Corporation (NASDAQ: MSFT) options contract with a strike price of $240 for $20.9. Since each contract controls 100 shares of stock, the value of the options contract at the start is $2,090.
If the delta of the option is 0.97, when the underlying stock moves up by $14, (the share price reaching to $264) the option moves up by $13.58 to bring the value of the contract to $3448 ($2,090 + ($13.58*100)). That’s a gain of 65% which is a lot more than the return of owning the stock itself.
Managing the Stock Replacement Options Strategy (Using Excel)
MarketXLS provides a convenient template for traders to manage their options strategies. All you need to do is enter the necessary inputs marked in yellow in the Active template sheet, and all the necessary details will be generated automatically.
All you need to do is Mention the Stock ticker in Cell E5 of the Active template sheet, enter the Expiry date of the option. A list of upcoming expiry dates has been provided adjacent to the input. Enter the Deep ITM Strike price you are looking to buy.
An entire comparison table is provided for the user to compare the profit from the stock concerning the profit from the options. It also generates a comparison chart and the payoff table concerning its different expiries. This template comes very handily for investors and traders to get complete details of their Stock Replacement Options Strategy and manage them well.
Benefits of Stock Replacement Options Strategy
It shall be clear from the above example that this strategy provides more significant gains by unlocking the potential of leverage. It gives the ability to make significant gains with less investment and avail the full benefit of any appreciation in the security.
There is limited loss as, in option buying, the maximum loss is always to the extent of the premium paid. Investors can also limit their volatility through strategic hedging under various resistance levels.
Conclusion/ Bottom Line
Beginners can also use the stock Replacement Options Strategy. It is a simple alternative to buying shares and reduces the maximum possible loss as well as takes advantage of the power of leverage. However, it comes with downsides because you can lose money if the share price doesn’t move at all and you don’t get the benefit of any paid dividends, but in the right circumstances, it can very much be the best strategy to use.
For more experienced traders, the ability to hedge the position if circumstances change and choose to what extent the position is hedged can be very appealing. However, hedging requires a high level of technical analysis skill to identify areas of resistance and support. If hedging is done in the wrong areas, significant profits can be lost.
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