Monday, March 15, 2010

Stock Replacement Redux

During Friday night's Options Action, a review of GS brought up discussion of stock replacement strategies. As traders we're constantly faced with the decision of when to take profits. Suppose we purchased 100 shares of GS last month when it was around $150. Over the past few weeks, GS has experienced a nice 15% rise in its stock price to $175. One dilemma facing us at present is whether or not we should take some money off the table. From a purely emotional standpoint, greed is tempting us to stay the course in the hope of garnering additional profits while fear is tempting us to jump ship to avoid giving back any gains. One potential method of compromise would be to enter a stock replacement strategy. The underlying rationale for entering the replacement is lowering your downside risk, while maintaining exposure to further gains if GS continues to rise.

The suggestion was to replace the long stock position with an April 180-190 vertical call spread (often referred to as a bull call spread or buying a call spread). Consider the risk graph:

[Source: MachTrader]

By purchasing the call spread for $280, we've drastically reduced the risk as well as capital tied up in the trade. In addition, we've also succeeded in maintaining upside exposure if GS continues to rise over the next month. In replacing the long stock trade with this call spread, the trader must obviously be willing to limit any additional upside to $720. Considering owning 100 shares of GS at $150 ties up $15K, dropping the capital requirement to $280 is worth limiting the profit potential in my opinion.

Stock replacement strategies highlight many of the advantages of using options to supplement a stock trader's game plan.

For related posts, check out:
The Replacements- As Good as the Original?
Options Action Posts

2 comments:

MarkWolfinger said...

Stock replacement strategies are a good idea and help preserve capital and reduce risk.

But the Yahoos on Options Action just don't get it. And they talk down to their viewers.

If stock is priced at $175, the unsophisticated investor - that's their audience - is going to be very hurt and disappointed to find that when the stock slowly move higher by another 5 points, they not only did not gain anything - but in fact lost money.

I don't watch this show, but I ask you: Was there any mention of this scenario?

A reasonable question for that audience to ask is: Exactly how was this a stock replacement strategy?

Tyler Craig said...

Good point. They didn't review every potential outcome, nor could they given it's only a 30 minute show. I guess the difficulty with throwing out any option strategy in a venue such as options action is you're probably never going to be able to cover every potential outcome and caveat involved with an options strategy.

To the extent to which any investing show get's investors interested in learning more about using options, it's a good thing IMO. I'm assuming the hope is that viewers have enough common sense to do some homework before blindly following ANY suggestions.