Using Call Options to Protect Your Gains While Maintaining Upside Potential

After moving mostly sideways from October through January the major stock indices have marched steadily higher in February and now stand at all-time record levels. In fact despite the slow start to 2015 the S&P 500 now up 3% for the year to date and the Nasdaq Composite up a healthy 4.2% and now just 2% away from reclaiming the dot.com bubble high hit 15 years ago.

But the performance of some individual stocks has been even more impressive and accounts for the bulk of indices gains. Apple (AAPL), the $750 billion gorilla, accounts for 20% of the Nasdaq 100 is up a whopping 25% in just the past two months. Netflix (NFLX) has gained 38% thus far this year. Even staid companies hit a succession of new highs such as Kroger Supermarket (KR) has climbed steadily, up 16% for in 2015 and over 60% over the past 6 months.

Given this type of performance and the not too distant memory of the financial crisis it’s understandable that money managers and individual investors alike are would not want to watch these profits turn into losses. There could be growing risks, both known such as the Fed set raise interest rates sometime this summer and the health of global economies in question, and unknown geopolitical events that could cause an increase in volatility or major correction. That said, the U.S. economy seems to be picking up steam the Central Bankers around the world continue to provide liquidity so the bull market very well might continue with stocks marching on to new highs.   It just might not come as smoothly as the prior few years.

Replace Rather than Remove

When people want to reduce risk but maintain 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 significant drag on performance in the form of the cost premium paid for 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:

• It greatly reduces the capital requirements and providing the flexibility to redeploy cash in new investments or opportunistic fashion.
• 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 currently trading at $132 a share.   Calls with a $120 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 share price declines so will the delta so the rate of losses decelerates.

In the example of above one could buy the $120 call that expires January 2016 for $2000 a contract. Assume shares gained 10% to $145 over the next three months. The value of the call would be approximately $3,200 or a 60 % 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 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 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 January $120 calls would be and risk is $26,000.

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 $20,000.

These compare with the $130,000 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 specific risk profile and investment outlook.   This could include more complex strategies such as spreads and combinations.

But 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 of above that would be 110 contracts. Which make you net long 11,100 shares or a 9,000 on a delta basis. Even if assumed 50% margin and cut those numbers in half it is still incredible increase in risk.

Drawbacks

Like anything in life, this comes with some compromise and potential pitfalls. Putting aside a mismanaging of position size one 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 $120 on expiration, or just a 10% decline, the calls will be worthless.

There is also the issue the premium paid for the call option which is a function of time and implied volatility. By using an ITM option we are buying an option that has intrinsic value which reduces the impact of time decay. In our Apple example the premium is $8 above intrinsic value. Meaning the breakeven point is $140 a share at expiration.

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.