Sunday, January 17, 2010

The Replacements- As Good As The Original?

Say you've accumulated a notable unrealized gain in a long IBM stock position. With Tuesday's earnings announcement quickly approaching you may be wondering how to manage your position. Though Big Blue doesn't have a history of huge earnings moves, there's always the remote chance of something crazy happening.

How about selling half your position? Or selling a covered call to partially hedge your position, or perhaps opting for the more complete protection of a collar? Though all are legitimate considerations with varying trade-offs, Friday night's Options Action suggested a Stock Replacement Strategy. The gist of a stock replacement strategy is to maintain one's exposure to further upside appreciation in a stock, but do so using derivatives, which may offer a more leveraged, cost-effective, or less risky approach.

The specific suggestion mentioned was to sell your IBM stock position and buy an April vertical 130-140 call spread for $4.00. One of the most obvious advantages to this strategy is the drastic reduction in risk. A long stock position (100 shares) of IBM currently has $13,200 of theoretical risk. The 130-140 call spread has a mere $400 at risk. The call spread also enables you to participate (to an extent) on any further appreciate in IBM stock. Since you entered a 10 spread for $4, your max reward is capped at $6. This limited profit represents the main drawback to this strategy. If a trader decided to take the stock replacement route they would have to be comfortable with capping any further gains to $600. Consider the risk graphs illustrating both positions:


[Source: EduTrader]

So is the stock replacement strategy an adjustment worth considering? You be the judge. As for me, I'm always open to plays that drastically reduce risk while still holding the door open to more profits.

2 comments:

Anonymous said...

Tyler,

The Collar you suggested [say keep stock; buy the 130 put / sell the 140 call] is equivalent to the stock replacement strategy [sell the stock; buy the 130/140 call spread].

Options Perception and Deception as Charles Cottle would say ...

Cheers
James

Tyler Craig said...

Good point James. The biggest trade-off in opting for the call spread vs. the collar would be the amount of capital tied up in the trade. Though the risk-reward is identical, the collar still ties up the entire cost of the stock, vs. the call spread only requiring $400.

Thus, it may be fair to say the call spread offered a more cost-effective, leveraged approach.