Options Theory: The Stock Replacement Strategy
Say you buy a stock and it jumps 10%. Gleefully you giggle your way to the bank to cash in. Then, after departing with your newfound dough in hand, the shares you just sold proceed to rip higher another 30%. With regret, you look back at what could have been. Suddenly, that 10% gain turns from victory to defeat.
You, friend, are suffering from seller’s remorse. It’s a soul sinking feeling experienced by many a trader who sold too early.
Today we’ll explore a time-tested tactic to avoid seller’s remorse forever. It’s known as the stock replacement strategy.
One of the benefits awaiting you in the options market is limited liability. Purchsing calls is dirt cheap compared to buying stock, and it offers similar upside. Much less risk for similar upside is the bee’s knees, baby. The stock replacement strategy illustrates just how fantastic a call can be. The technique is simple: swap out your stock with a long call. For every 100 shares of stock you own, buy one call option.
If after switching your stock for calls, the share price plummets, no sweat. The long calls carry much less risk. Alternatively, if the stock keeps melting higher then glory hallelujah! Your calls will allow you to continue racking up gains.
Sound like a win-win?
That’s because it is.
Which call you buy depends on your desired duration of exposure. If you want to maintain your position for another three months then swap out your stock for a three-month call.
As for which strike price to buy, that too offers trade-offs. If you want the call to almost perfectly mimic your stock position then buy deep in-the-money. A delta around 80 to 85 should do the trick. If you’re looking instead to minimize the cost, buy one strike in-the-money. Finally, if you want to replace your stock with a few cheap lotto tickets caryying little risk but potentially explosive upside if your stock gets jiggy with it, then buy out-of-the-money.
Here’s an example.
Suppose you bought 100 shares of Micron Technology, Inc (MU) on February 20th after it made an appearance in our world-class Options Report as a bullish breakout candidate. Your purchase price was $45 which means it cost you a cool $4,500. With the stock now flirting with $55, you’ve officially accumulated an unrealized gain of $1,000 or a 22% gain.
Why you so smart, eh?
Now you’re faced with a torturous dilemma. Do you exit now and watch it continue higher without you? Or do you stay in and inevitably watch the stock crumble?
I say do a bit of both with the whiz-bang, dope-diggy stock replacement strategy. Sell the stock at $55 thereby locking in the $1,000 gain and buy a June $50 call for $820. You now have continued exposure through June at a pittance of the risk. Your downside has shifted from $4,500 to $820. Meanwhile, your potential reward remains unlimited.
It is true that your new position will suffer a bit of time decay ($320 over the next three months), but it’s a fair trade for having limited your risk so substantially.
Remember this tactic next time your inner fear and greed are playing tug-of-war with one of your profitable stock positions. Replacing your stock with calls gives both emotions a bit of what they so desperately want.
