Stock Replacement, a Smart Options Strategy for Traders

Stock Replacement, a Smart Options Strategy for Traders

Posted On March 29, 2022 1:59 pm

In 2018, I wrote about a stock replacement strategy when the market was hitting an all-time high.  With nothing but clear skies, no visible ‘overhead’ on the charts, and an economy seemingly firing on all cylinders, investors might have rightly viewed advice to temper their bullishness with skepticism.

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However, that environment and attitude seem worlds away, so I thought it would be a good time to review the use of a Stock Replacement Strategy, with an emphasis on how it reduces risk without limiting upside exposure.

A replacement strategy is essentially replacing ownership of shares with the purchase of call options.  This is a good time to review the process and benefits.

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 can have a significant drag on performance in the form of the cost premium paid for put options.

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

  • It greatly reduces the capital requirements and provides 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 these 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) where premiums get eroded.  I’m assuming anyone who has enjoyed 2021-2022 gains has a long-term mentality.  So using LEAPs, or options with a year-plus also make sense.
  2. Choose a strike price that has a delta of at least 0.70.  This will usually mean buying a call that is about 10%
  3. 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 around $175 a share.   Calls with a $160 strike price have a delta of 0.72; for every $1 move, the value of the option will gain or lose approximately $0.72.  But, delta works on a slope, as the price rises and call moves further into the money, the delta increases to the point it approaches 1.0.  In other words, the position gets longer or more bullish as price rises.   Conversely, if the share price declines so will the delta.  Hence, the rate of losses decelerates.

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In the example above, one could buy the $160 call that expires in October 2022 for $1,700 a contract; a steep discount to the $17,500 it would take to buy 100 shares.

Now, assume shares gained just 10% to $192 over the next three months. The value of the call would be approximately $4,500 (a 75% increase).  This assumes no change in implied volatility. But, it takes into account three months of theta, equating to $1.05 of decay.   The delta at that point would be 0.98, or essentially a one-to-one correlation.

Obviously, options leverage greatly boosts the return, or losses, on investment on a percentage basis.

Calculating the Contracts

This brings me to an important point in 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 call with a current 0.72  delta.  Be aware as the price rises, your net exposure will increase up to a maximum of a 1,300 share equivalent.  In the Apple example, your total cost for 13 of the October $160 calls would be $22,000, which is your total risk. 

If you want to simply maintain a maximum 1,000 share equivalent, you’d 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 $175,000 it would cost to own 1,000 shares.  Or, assuming a 50% margin, that’s still a hefty $87,500.

Of course, these are just basic examples and one could tailor a position to align with the 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 national value of $175,000 you don’t want to buy.

In our example above, that would be 110 contracts.  Which makes your net long 11,100 shares or 9,000 on a delta basis.  Even if you assume a 50% margin and cut those numbers in half it is still an incredible increase in risk.


Like anything in life, this comes with some compromise and potential pitfalls.  Putting aside a mismanaging of position size, one must 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 150 on expiration, or just a 15% decline, the calls will be worthless; i.e. a 100% loss!

Two other considerations are that, unlike shareholders, options owners don’t qualify to collect dividends and there could be tax implications of selling a stock that has significant gains.  

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

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.