The stock market is hitting all-time highs and investors are torn between the possibility of an economic downturn or that we are entering a new leg of the bull market. 

It’s understandable that money managers and individual investors alike would not want to watch these profits turn into losses.  There could be growing risks, such as a reacceleration of trade tariffs, unknown geopolitical events, and the approaching election season that could cause an increase in volatility or major correction.  

That said, the U.S. economy seems to be on stable ground and the Central Bankers around the world continue to provide liquidity so the bull market very well might continue with stocks marching on. It just might not come as smoothly as the prior few years. 

Replace Rather than Remove 

When people want to reduce risk but maintains upside exposure they usually think in terms of buying put protection as a form of portfolio insurance.  While this can be effective in minimizing losses during a decline, it comes it can have a significant drag on performance in the form of the cost premium paid for the put options.  

An alternative approach is a stock replacement strategy in which one swaps owning shares of the underlying for being long call options. The two main advantages of a replacement strategy over a married put position are: 

1. It greatly reduces the capital requirements and providing the flexibility to redeploy cash in new investments or opportunistic fashion. 
2. It offers the benefit of the leverage of options to maintain greater upside potential on further gains. 

Basic Replacement

My basic rules of thumb for implementing this are:

1. Buy call options that have at least six months remaining until expiration.  This will help reduce the negative impact of time decay (theta) in which premiums get eroded.  I’m assuming anyone who has enjoyed the gains of the past year or two has a long-term mentality, so using LEAPs, or those options that have a year or more, also makes sense.
 
2. Choose a strike price that has a delta of least 0.70.  This will usually mean buying a call that is about 10% in-the-money.  Let’s take a look at Apple (AAPL) which is set to report earnings after the close today. 

The stock is currently trading at $245 a share.   Calls with a $225 strike price have a delta of 0.72.  This means that for every $1 move, the value of the option will gain or lose) approximately $0.72.  But remember delta works on a slope, meaning that as the price rises and the call moves further into-the-money the delta will increase to the point it approaches 1.0 meaning the position gets longer or more bullish as price rises.   Conversely, if the share price declines so will the delta so the rate of losses decelerates. 

In the example above, one could buy the $225 call that expires June of 2020 for $1,700 a contract.  This is a steep discount to the $24,500 it would take to buy 100 shares. 

Now, assume shares gained just 10% to $270 over the next three months. The value of the call would be approximately $4,500 or a 75 % increase.  This assumes no change in implied volatility but takes into three months of theta into account which would equate to $1.05 of decay. The delta at that point would be 0.98 or essentially one-to-one correlation.  Obviously the leverage of options greatly boosts the return, or losses, on investment on a percentage basis.   

Calculating the Contracts

This brings me to an important point regarding determining the number of contracts one should buy.  There are two basic approaches: delta-equivalent or share-count.  

In the delta equivalent, if you own 1,000 shares and want to maintain the same exposure, you would need to buy 13 contracts of a call — with a current 0.72 delta.  Be aware as price rises your net exposure will increase up to a maximum of 1,300 share equivalent.  In the Apple example, your total cost for 13 of the June $225 calls would be and risk is $36,000. 

If you want to simply maintain a maximum 1,000 share equivalent, you would buy 10 contracts.  Again, the current net exposure would be only 700 shares on a delta basis. In this case, your total cost and risk is $30,000.

These compare with the $245,000 it would cost to own 1,000 shares.  Or assuming 50% margin that’s still a hefty $65,000. 

Of course, these are just basic examples and one could tailor a position to align with a specific risk profile and investment outlook. This could include more complex strategies such as spreads and combinations. 

What you never want to do is use a dollar-equivalent approach. That is if you owned 1,000 shares of Apple, which currently has a notional value of $150,000, you don’t want to buy $150,000 worth of calls.  In our example above, that would be 110 contracts. Which make you net long 11,100 shares or, 9,000 on a delta basis. Even if you assumed the 50% margin and cut those numbers in half, it is still an incredible increase in risk. 

Drawbacks

Like anything in life, this comes with some comprise and potential pitfalls.  Putting aside a mismanaging of position size, you must always remember that if the option falls out-of-the-money, there is the potential for 100% loss at expiration.  In our example, that means if shares of Apple are below $225 on expiration, or just a 9% decline, the calls will be worthless.  

Another consideration is unlike shareholders, owners of options do not qualify to collect dividends.  Given that many of the past years’ best performers have been driven by a “bond equivalents” such as staples, utilities, REITs and MLPs, this may be counter to the reason you already own the shares. And finally, selling a stock that has significant gains may have unwanted tax implications.

But, for those sitting on shares with healthy profits that want to reduce risk but maintain upside exposure, a stock replacement strategy makes sense.

CBOE shares were trading at $116.56 per share on Wednesday afternoon, up $2.72 (+2.39%). Year-to-date, CBOE has gained 20.25%, versus a 22.85% rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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