Since I began this series on discussing strategies which take some investment chips off the table, the Central Bank inspired rally has hit a bit of a speed bump. The second week of October the market averages sold off pretty hard. This proves that markets don’t go higher, forever. In fact when looking at the price chart of the SPX index, the rally off the lows on June 1st hasn’t exactly been a smooth ride and may have scared some investors out of the market completely.
Source: OptionsHouse Prodigio
So how can a trader remain in the market without getting shaken out when the market experiences those sudden turns? Long stock traders may utilize stop orders but run the risk of being stopped out just before the next leg up in a longer term rally. The other notable risk associated with stops is GAP risk. The stock price may gap thru the stop level overnight, not providing the hedge to the downside. However, options can provide a way to create a dynamic hedge. Using call options and Call spreads as a “replacement” for long stock positions can offer long exposure to the market, while giving the holder a dynamic stop loss price at a predetermined price point. For investors already long stock in this market using call options is a way to maintain a long position but take some chips (risk and money) off the stock market table.
First the basics:
The risk to a long stock position is the share price may fall – theoretically could fall to zero so the entire purchase price is really at risk. The risk to a long call position is 100% of the premium paid for the call if the share price is below the strike price at expiration. This premium is usually a fraction of the full stock price.
This is why this strategy is also known in institutional trading circles as Cash Replacement or Cash Extraction strategies.
Here’s how using stock replacement works in taking some “chips” off the table. Using the option delta again is the key to determining the proper strategy. Exactly the same as the prior two blog posts I wrote in this series on how to remove some risk from the market, the delta of the call will indicate the amount of risk you will have relative to a 100 delta long stock position. Obviously, a long stock position experiences dollar for dollar profit or loss relative to the movement of itself. A 70 delta call option however, theoretically moves in price at 70% of the movement of the underlying share price. If the stock rises 1 dollar a 70 delta call option should increase in market value by 70 cents. Remember, deltas and all the Greeks are theoretical measures. The financial models from which they are derived assume that factors such as implied volatility of the options, interest rates and even time are all unchanged and all that actually changes is the underlying stock price when calculating Delta. Likewise if the price of the underlying stock or ETF falls 1 dollar the 70 delta again implies that the market value of the call option will only fall 70 cents. So quite simply replacing a long stock position with a 70 delta call will result in 70% of the risk associated with the ownership of stock.
Let’s look at a real life example to measure the costs and benefits of using this strategy.
Apple shares (AAPL) have been a great long term stock hold but since hitting 700 per share in mid-September have pulled back 10% to close the week at 630 dollars per share. If you have a long position of 100 shares you have 63,000 dollars invested in this position. You could replace your long stock with a long in the money December 590 strike call option.
It is a 71 delta option with a premium for 1 contract controlling 100 shares of 58.00 dollars. Immediately this extracts the difference between what you take in by selling your long stock 63,000 – 5800 = $57,200 (Consult your tax advisor to understand any tax consequences). However increasing the cash in your account is only one of the benefits of this strategy and not the point of this blog. We want to pull some chips (risk) off the table and by buying this call we reduce our absolute risk to that of the premium paid $5800 from long stock of 63,000 dollars! Immediately our risk profile will more closely represent that 71 delta we referred to. Each dollar move in AAPL up or down we should theoretically make or lose about 70 cents. Further the delta of this option is not static. As the price of AAPL shares rises, the delta will increase toward 100 and subsequent price moves will mirror that of the stock. Should the stock continue to fall, the delta will decrease toward zero – remember, you can’t lose more than 100% of the premium you paid no matter how low Apple stock price might fall.
These benefits are not free. The 58 dollars this option costs has additional time value or extrinsic value relative to the stock price. The stock is trading 630 dollars, and the option has a strike price of 590 dollars. 630-590 is 40 dollars of parity value. The extra premium of 18 dollars that this option cost is the extrinsic value. The stock must appreciate 18 dollars, or 2.85% in order for this option to be profitable. Turning this long call into a long call spread can achieve a number of things. It will reduce the amount the shares have to appreciate to become a profitable trade; it also takes some more chips off the risk table, though it will limit your potential gains. Again nothing comes free in option trading. For reducing the premium paid by selling a higher strike call you have to be willing to limit the upside profit potential of the trade.
700 dollars per share was the recent top in Apple, so you could choose to sell this strike call and receive about 10 dollars. This represents over 55% of the extra premium paid for the 590 call and would reduce the amount Apple needed to gain to 8 dollars or 1.26% higher from here. Selling this options will limit the maximum potential gain to the difference between strikes less what you paid for it 110-48= 62.00 = $6200. Or you could take a bigger slice out of the extrinsic premium by selling the 670 call at 17.75. This almost covers all of the extra 18 dollars in premium, but again it limits the potential max gain to 80-40.25 = $3975. You have to look at these max gains vs. your max loss, the total amount of premium paid to get a true picture of return on risk. The 590-700 call spread you are paying 4800 for a potential gain of 6200 = 129% potential gain. The 590-670 call spread risks 4025 to potentially make 3975 a potential 98% return. These are max losses compared to max gains your actual return may likely be somewhere in the middle.
More importantly look at the delta to determine the best strike. How many chips do you want to take off the table? The 700 strike will reduce your exposure another 22% down to 49% (71-22 delta) and the 670 strike would reduce exposure another 34 deltas to only 37 delta (71-34) or 37% of the risk associated with long stock.
Again, this is not a buy, sell, or hold recommendation, but simply an example of how stock investors can use the stock replacement strategy to take some chips off the table on an individual position. It allows you to remain with positive exposure to the market but in a more risk managed and hedged fashion.