Is Now the Time to Think About Stock Replacement?

Last week, the S&P 500 took a step backwards, dipping 4.6%. It was a rocky ride, with large drops happening on Wednesday and Friday. Given these wild swings and looming uncertainty, the prospect of looking into stock replacement as a method of maintaining long exposure to the market, while capping potential downside, is appealing.

So when does a stock replacement strategy work best?

The basics of a stock replacement strategy

Any time you trade options, you are effectively trading shares of stock. A stock replacement strategy takes long shares of stock and converts it into an options position with a similar upside potential.

Frequently, it substitutes a long stock position for long calls. Often, the calls will be longer-dated and deeper in-the-money. This is a way to protect the value of the options. If you purchased shorter-dated calls, the time decay on the options would be quite high. That’s because theta decay is exponential; the most rapid theta decay happens in the last 30 days. In addition, the price would be very sensitive to the price of the underlying stock.

As a result, your options portfolio wouldn’t so much act as a stock replacement as it would be betting on a short-term move in one direction or another.

The benefits of a stock replacement strategy

Let’s take a look at a portfolio of stock vs. options.

Apple stock: $108.86*
19 Mar 21 $90 calls: $22.00
Break-even: $112
Days until expiration: 139

Portfolio of 100 shares of Apple stock: $10,886 in capital

Portfolio of (1) 19 Mar 21 $90 call: $2,200 in capital

*Closing prices as of October 30.

What does this do?

1. It raises capital.

The stock replacement strategy costs $2,200 in capital, which gives this portfolio $8,686 of capital. What does that capital buy? Opportunity.

If you are fully invested right now, that won’t change with day-to-day fluctuations in the stock market. If the market goes up 5%, you will still be fully invested. If the market goes down 5%, you’re still fully invested.

Your only option to take advantage of opportunities or protect your downside is to sell your holdings.

When markets go down, you want to make sure you have “dry powder” to deploy. Converting stock positions into options positions of the same size ensures that there is capital on the sidelines to deploy should you want or need to.

2. It insulates your portfolio from large moves downward.

The stock replacement strategy creates a defined risk trade. The most that the trader can lose is the premium paid, while the gains of the trade are unlimited. If Apple goes to $120 or $130, the trader capitalizes on that upside. However, if Apple stock falls to $85, the trader only loses the $2,200, and is free to buy back the stock, should he want to do that.

3. Higher return on invested capital (ROIC).

Given that the capital put into this trade is reduced from more than $10,000 to $2,200, the invested capital is reduced by 75%. That increases the return. A $100 additional return is a 4.5% return, and increase from the 1% return at a $10,000.

Of course, leverage is a double-edged sword. The only returns that should really matter are portfolio returns. And in a world where you do a stock replacement strategy to reduce risk and raise capital, ROIC may not be the largest consideration.

The downsides of a stock replacement strategy

Changing from a portfolio of stocks to options doesn’t come without things that you should consider. Here are a few.

1. It has a capital cost.

The trader will end up paying roughly $3.14, or 3%, in premiums for buying the option. On 100 shares, that equates to a cost of $314. Of course, that cost is mitigated if Apple shares fall below $90; however, at any price above $90, the trader is less well off from a P&L perspective, strictly speaking.

2. It creates a taxable event.

Selling a stock creates a taxable event. For a long-term holder of the stock, that could be as high as 20% of the long-term profits on the stock due to Uncle Sam at the time of the next tax bill. Selling now, when Apple is up 45% on the year and just a little ways after reaching all-time highs, will create a taxable event for nearly everyone who bought stock, whether it was this year or in the past.

3. During high implied volatility times, the options are more expensive.

It’s simple: when there is more uncertainty, option prices increase. So if you’re employing a stock replacement strategy in order to mitigate future uncertainty, that will be reflected in the capital cost.