For the longest time, I have said that the only thing that the stock trader really needed to know about options is how to use them to replace his or her own stock position.
If stock traders can learn and understand just one simple strategy, it can greatly affect their performance to such a degree that they would not need to know anything else.
Of course, this pre-supposes that they already know how to trade stock, and have a clear understanding and working knowledge of technical and fundamental analysis. If you possess both, you will be happy to read this article.
The Stock Replacement Strategy is, on the surface, a very easy strategy from the point of execution. We are simply going to be buying a call if we think that the stock is going to go up; and buying a put if we think that the stock will trade down.
There are several advantages to using the options in place of the stock. Let’s take a look at these advantages. First, there is cost efficiency. The equivalent-sized option position will be a fraction of the cost of the stock position. The ability to use less capital is great from a risk management standpoint.
Spend less, risk less! It is also an advantage from the standpoint of simple affordability. Ever trade GOOGL or PCLN? Well, now you can! Plus, now you have a lot more cash in your account to do other things!
We have spoken to the fact and the mathematical proof that owning an equivalent-sized call position is less risky than owning a stock position. In a day when risk management has become so important, less risk is better risk; and nothing controls risk better than options!
We also get a much better percentage return from the use of options via the mathematical leverage we obtain in the purchase of the option. Finally, the use of the Stock Replacement Strategy allows us to do something that simply can’t be done with stock! With the Stock Replacement Strategy, we can lock in profits AND reduce our risk WHILE keeping our same-sized position through a technique called rolling.
Think of all those times when you sold out of a stock too early because you were scared you would lose your profits if the stock reversed.
Meanwhile, the stock runs up another 50% making you want to pull your hair out because you missed it! Now, with the Stock Replacement Strategy, that is no longer a worry!
Although the execution seems to be very simple, the selection process of the proper month and strike is not so simple. I wouldn’t call it rocket science or brain surgery, but there are some intricacies to making the proper decisions as to month and strike depending on the identified opportunity and the current situations surrounding several different variables, such as: overall market condition, industry news and situation, volatility, and of course the different sensitivity levels of the different option choices.
This is the part of the Stock Replacement Strategy that needs to be learned to insure consistent and optimal use of the strategy.
Now that we have discussed the idea of stock replacement, we must talk about which option to use to properly set up the Stock Replacement Strategy because as you are about to see, not all options are viable and correct for the Stock Replacement Strategy!
Did you ever think that a stock was going to go up? Did you ever decide to buy some calls to take advantage of that upward movement that you expected? Were you then correct about the stock going up as you anticipated? But, did you find that even though the stock went up, your call price actually went down? Not fun, huh? Well, we all should know the reason for this, as it was discussed in a prior article on volatility.
The reason for this breaks down to something very simple…you picked the wrong option! You probably bought an out-of-the-money option which is much more influenced by time and volatility, than it is by stock price.
When using the Stock Replacement Strategy, we must remember that in reality, we are doing a STOCK trade. We are just using options. We are replacing the stock position with an option position (long calls).
The reasons for doing so have been spelled out in my last article How Options Fit In Your Portfolio. The secret is in understanding that in order to properly “replace” the stock; you must find an option that acts like the stock, or has similar characteristics to stock.
Here is a good example of what I am talking about. If you were a basketball coach, and your center, a 7 foot 3 inch tall man got injured, you wouldn’t replace him with a 5 foot 11 inch player! You would choose someone that is similar to the player you needed to replace.
So you would look down your bench and you select the 7 foot 2 inch back-up center to go in and play! This is the same for options in the Stock Replacement Strategy!!!
When you look at stocks and options from a standpoint of characteristics, it is best to look at their Greeks. In the case of stocks, you see a one dimensional asset. Stock is pure delta! It is 100% delta by mathematical definition! It is the highest delta you can get! But, while extremely high in delta, it has 0 gamma, 0 vega, and 0 theta.
So, if I was looking to replace the stock with an option, then I would want to use an option that has a high delta, little-to-no-gamma, little-to-no-vega, and little-to-no- theta. Thus, in essence, I am looking for a high intrinsic, low extrinsic value option. We find those exact characteristics in the in-the-money options…most particularly the 80 to 85 delta options. This is the “sweet spot.”
These “sweet spot” options are deep-in-the-money options that are heavy in delta, while being very light in gamma, vega, and theta. They have a lot of intrinsic value and little extrinsic value. Together, this means that this option (80 to 85 deltas), unlike the at-the-money or out-of-the-money options, will react strongly to the movement of the stock but not so much to the movements of time and volatility.
If you recall from the first paragraph, this is exactly what we want; to play and focus on the movement of the stock–NOT the movement of time and or volatility! So, now that we know which strike to use, the question becomes which expiry.
This again is pretty simple. Your goal here is to try to match the length of time you think the movement will take, to a similarly-timed expiry. Translation: if you think the movement you expect is going to take 3 months, buy a 3-month option. If you think it will take 3 weeks, then buy a 3-week option.
You do not want to buy too much time, nor do you want to buy too little time. I know that it is not an exact perfect science, so just coming close is definitely good enough. You just don’t want to buy a 9 month option to trade a 2 week movement.
So, go out to the month you select (based on how long you think the movement will take) and go to the 80 to 85 delta option. That is the one you want to own!
Are there exceptions? Of course there are. We are talking about the market, so there are always exceptions! I’ll discuss more of this in my next article.
See you all next time!
Ron Ianieri is owner of Ion Options a company he started in 2010. He is also lead instructor at Options Monster Education and editor of the highly successful newsletter “The Income Strategist”. Ron has been trading options for more than 27 years and is also the author of the book “Options Theory and Trading” published by John Wiley and Sons. Currently Ron travels the world teaching investors the same successful Options class he developed during his years on the trading floor.