Tuesday, August 10, 2010

Stock Replacement Strike Selection

In Steven Sear's recent column How to Avoid Seller's Remorse, he expounds on some alluring advantages to the stock replacement strategy. One key takeaway is the drastic reduction in risk that occurs when one switches from stock to options. Yet another is the fact that options are relatively inexpensive right now given the VIX's steady decline toward the 21 level. I received a question regarding how one might go about selecting strike prices when implementing the stock replacement.

While there may be a few different tactics for deciding the optimal strike price, perhaps the easiest and most direct is to approach strike selection from a delta perspective. Since delta can be used to determine equivalent stock and option positions, it is particularly helpful when assessing which strike price provides the ideal outcome. Suppose you purchased 100 shares of AMZN at $122. Given its recent rise to $128, you're sitting comfortably on a $600 unrealized gain. In addition, your position's delta is +100. Suppose you wanted to replace your long stock position by purchasing a January 2011 call option. Consider the following two choices - a 100 strike call and a 140 strike call:

[Source: MachTrader]

While the deep ITM call costs more ($3200), you gain a higher delta (+84) making the position a closer equivalent to the shares of stock. Furthermore, the majority of what you paid is intrinsic value and will remain in the option so long as AMZN doesn't drop.
Though the OTM call is much cheaper ($730), you acquire a lower delta (+39). The ITM call was the theoretical equivalent of owning 84 shares of stock, the OTM call is the equivalent of owning 39 shares of stock. Since the call strike is 140, 100% of what you paid is extrinsic value and will incrementally erode away if AMZN doesn't rise past $140 by expiration.

In summary - if you want the call option to behave in a similar fashion to your stock position, buy an ITM higher delta option. If your focus is rather on reducing the amount of risk capital in the trade and you don't mind traversing the cheaper, lower probability route, consider OTM options. I suspect most traders reside somewhere in between.

For related posts, readers can check out:
The Replacements - As Good as the Original?
Stock Replacement Redux


MarkWolfinger said...

One important consideration not mentioned:

If you are indeed thinking of this trade as a stock replacement, then it is probably right to assume that one intends to hold this option for a significant period of time. [The investor mindset, rather than the trader mindset]

If true, buying OTM options that are loaded with vega risk and high time decay (due to long holding period) is a pretty bad strategy.

I'd suggest options that are less ITM and with a shorter lifetime.

Tyler Craig said...

Thanks Mark.

I agree 100%. My focus was primarily on the delta perspective, but traders certainly do open themselves up to volatility and time decay if they take the ATM or OTM route.


Interesting stricke prices.