Most stock investors firmly believe that options are high-risk investments, only suitable for unrefined traders. But holding expensive stocks through turbulent markets can prove to be an even less civilized approach. October has historically been a dangerous month for equity investors and several analysts say this October may be historic in that regard. Using options, namely the stock replacement strategy, can tame the wildest of risks.
Before we describe the stock replacement strategy you must understand one critical point: Options represent tradeoffs in risk and reward. They are not superior or inferior to stock, they present a different set of risks and rewards and it is up to each investor to determine which is right for him.
This strategy is designed as a substitute for purchasing shares. It provides nearly the same profit if the stock price rises but only exposes you to a fraction of the downside risk. To understand the tradeoffs, you must understand the risks and rewards of each strategy.
Assume you are bullish on Chevron-Texaco (CVX), which is trading at $90. If you purchase 100 shares of stock, it will cost $9,000 and you will earn dollar-for-dollar if the stock rises but lose dollar-for-dollar if it falls.
The important point is that the profit and loss profile for a long stock position is a straight line. It shows that you continue to profit as the stock price rises but accept a large, unknown downside risk for that opportunity. While it’s true that the maximum loss is $9,000 at a stock price of zero, the chance of that happening is remote. So aside from that one known value we don’t really know what your losses could be. You’re investing in the face of uncertainty.
We can improve the risk-reward profile by using the stock replacement strategy. This strategy buys a deep-in-the-money call with a delta in the range of 0.80 to 0.85.
An option’s delta shows how sensitive an option’s price is for the next dollar move in the underlying stock. If you buy an 80-delta call for $10 and the stock immediately
rises
$1, the call will be worth $10.80.