Ride a Stock Rally With Limited Dollars at Risk

With stocks assailing record highs -- and the Dow just off its best streak in 30 years -- some speculators are getting nervous about a correction (or at least a pullback) or a volatility surge. However, as Schaeffer's Senior V.P. of Research Todd Salamone has noted several times of late, the stock replacement strategy -- trading outright share ownership for in-the-money call options -- allows traders to enjoy additional upside without putting everything on the line.

How Stock Replacement Strategy Works

The stock replacement strategy involves replacing shares of an equity or exchange-traded fund (ETF) with in-the-money call options. This allows traders to continue to benefit from the underlying's move higher, while also decreasing their dollars at risk in case of a sudden downturn.

When choosing which call options to purchase, traders should look at deep in-the-money options with a high delta. As the underlying equity increases in value, the value of an option with a delta close to 1 will increase by almost the same amount, so traders are able to limit their risk without sacrificing much profit. In other words, replacing shares with call options allows traders to maximize their leverage.

A Tale of 3 Traders

Let's look at an example to see how this strategy might work. Assume Traders A, B, and C all bought 100 shares of Stock XYZ when it was trading at $50 a year ago. Since then, XYZ has doubled to trade at $100 per share -- meaning they all have $5,000 in profits -- but the stock is now bumping up against potential century-mark resistance.

Trader A decides it's time to take profits and sells her 100 shares for a total of $10,000 -- a $5,000 profit from her initial investment. If XYZ drops 10% to $90 over the next few months, Trader A's decision to sell would prove wise and well-timed. If XYZ surges 10% to $110, however, Trader A has missed out on another $1,000 in profits.

Trader B, meanwhile, decides to ride out the potential speed bump near $100, and holds on to his shares of XYZ. If the stock falls 10%, his net profit would stand at $4,000 -- a $1,000 hit. If XYZ rallies to $110, Trader B's shares will now be worth $11,000 -- a $6,000 gain on his initial investment.

And then there's Trader C, who decides to implement the stock replacement strategy in the face of round-number resistance. She sells her XYZ shares for $100 apiece, or $10,000 total, pocketing $5,000 from her initial investment. She then uses some of those proceeds to buy a June 95 call on XYZ, currently asked at $8, or $800 (x 100 shares per contract).  

If XYZ drops 10% by June options expiration, the 95-strike call will expire worthless. Trader C will forfeit the $800 paid for the calls, but has still netted a healthy profit of $4,200 from her initial $5,000 investment in XYZ. That's still $200 more than Trader B's take-home profit in the same situation.

If XYZ surges to $110 in the near term, extending its rally, the deep in-the-money 95-strike call will sport an intrinsic value of $15, or $1,500 (x 100 shares) -- a gain of $700 from her call purchase. Including the shares she sold originally, Trader C would walk away with a net profit of $5,700 on XYZ -- very close to Trader B's profit in the same situation. Or, Trader C could exercise those options and buy her 100 shares back at $95 apiece -- a huge discount to their current price of $110.

In conclusion, the stock replacement strategy allows traders to profit from a continued rally in their shares, but limit risk in the event of a downturn. Of course, nervous traders could also consider buying protective puts on the underlying, especially considering options are attractively priced right now, but that strategy merely locks in a selling price in the event of a downturn (like "insurance").

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