What is the stock replacement strategy? The stock replacement strategy involves taking long positions in deep-in-the-money call options in stock that you would otherwise own.
It works best with stocks that you want to hold for the intermediate to long-term, in a general bull market with stocks that are performing well, on a general price uptrend in strong sectors that are leading the bull market.
Downsides of holding stock
If you’ve been investing in stocks for some years, you will notice what happens during up-markets and during down-markets. By that, I don’t mean the obvious, in up-markets your shares go up and in down-markets, your shares go down.
What I am referring to is how you react.
I know there is nothing I like better than to log onto my brokerage account and get that happy dopamine rush when I see my positions creeping up. Not necessarily all of them at the same time, but as long as the portfolio as a whole is on an upward march, all is well with the world.
The other experience is when you see all your positions heading down. That isn’t so great.
Depending on what kind of investor you are will determine to a large extent how you deal with these two psychological and emotional reactions.
Long-term position building
If our approach to investing is to build long-term positions, then seeing their value drop in down-markets is going to come as part of the package.
But, we could ask, are there other ways to deal with this rather than just passive acceptance?
Certainly, we could hedge. But then you have to decide when do you hedge, what would trigger a decision to hedge, and by how much would you hedge? And hedging costs money and the more you hedge the more it costs.
Enter the stock replacement strategy
The stock replacement strategy does just that.
By taking long positions in deep-in-the-money call options that have six to three months to expiration, we can ensure leveraged exposure to potential upside movement while reducing our exposure to potential downside price movement.
Possibly even better, well at least this is the part that I like the best, if our investments perform well for a period, we will be able to take profit and reduce our risk exposure. We need to carefully select the stocks that we replicate in this way using options. We will then be able to reduce our risk to the extent that we withdraw all of our original investment and still stay in the option position.
Because our intention is to operate a strategy on a long-term basis, we need a system. Our system will need to do these things
- Rules for selecting stocks or ETFs that are suitable for the stock replacement strategy
- Rules for when to exit a position
- Rules for selecting options in the underlying stock or ETF, by expiration date, strike price, and other factors
- Rules for position sizing
- Rules for when and how we roll our options forward
- Rules for how many stock replacement positions we should have in our portfolio
That is a lot of rules. So let’s take them one by one.
Selecting suitable stocks or ETFs
I guess the important point here is that we are using a system to replicate what is basically a long-term buy and hold strategy. Long-term buy and hold really works best in a general bull market. Fortunately for us, bull markets tend to last longer than bear markets.
The best long-term positions to take in a long-term bull market are in the strongest sectors that are outperforming the market. This article explains how to identify strong sectors. If we compare the performance of the major sectors against the Standard and Poor’s 500 index, since the November 2020 election, this is what we see.
What we see is a fairly consistent picture. In other words, the sectors that are now strong are the same ones that have been strong since the first day of trading after the US election results were known. That was Monday 9 November 2020. Just to test this point, here is what that chart looks like if we push back the start of the timeline to July 2020.
The change is most noticeable with the energy sector. Up until November 2020, the energy sector ETF, XLE is heading steadily down indicating that the energy sector is underperforming the market. But then on 9 November, XLE suddenly makes a turnaround and heads up, outperforming the market and the other sectors.
Right now at the end of March 2021, the strongest sectors are energy, consumer discretionary, and financials. That can change of course and you always have to be cognizant whether we are talking long-term strength or intermediate or short-term strength.
For our purposes, we are interested in identifying those sectors that are showing long-term strength.
So now that we’ve sorted out the strongest sectors we can either pick one or more Exchange-Traded Funds, or ETFs that cover the top 25 percent of sectors or we could look for the strongest stocks in those sectors or we could do a bit of both.
Personally, I like to do a bit of both but that is just me.
For the sake of argument, let’s say that we wanted to take long positions in one broad sector ETF and one major stock from each of those sectors as follows
- XLF – The Financial Sector SPDR ETF
- XLE – The Energy Sector SPDR ETF
- XLY – The Consumer Discretionary Sector SPDR ETF
- GS – Goldman Sachs
- XOM – Exon Mobil
- F – Ford Motor Company
When to pull out of funds and stocks
The point here is, we will want to periodically review the long-term relative strength of our funds and stocks. When there is major sector rotation and yesterday’s darlings become today’s dogs, we will want to exit the underperformers and move into the new leading stars.
We want to achieve a steady and manageable approach and avoid jumping in and out of positions. Our system, therefore, needs to be undertaking this review at least every quarter.
When we review, we check that the sectors we hold positions in are still among the strongest, at least the top half of all sectors by long-term relative strength. We also check that our individual stocks are in the top half of their respective sectors by long-term relative strength.
One of the advantages of selecting major sector ETFs and strong stocks in those sectors is that these are going to be very heavily-traded and liquid stocks. This will typically mean that the options boards for these stocks are well-populated, that the bid-ask spreads are reasonable and the options are liquid.
This is important because we want to be able to get into and out of these positions whenever we need to and with minimal slippage.
The delta of an option is particularly relevant to the stock replacement strategy because when we take a long position in an option we want to know the relationship of the option price to the price of the underlying stock or ETF.
In effect, when we own an option it is like owning or controlling a certain number of shares. It is the delta of the option that tells us how many shares we effectively own.
There is one important feature of the stock replacement strategy. That we seek to enter and stay in options whose delta optimizes our exposure to price movements of the underlying stock or ETF.
One side of this balancing act is that we have increasing exposure to increases in the price of the underlying stock or ETF.
The other side of the coin is that our exposure to declines in the price of the underlying stock of ETF increasingly diminishes.
This is easier to see with some simple numbers.
If we have a position with a delta of 0.70 and the price of the underlying increases by $10 our option might increase in value by $8. But if from the same starting point with a delta of 0.70 the price of the underlying decreases by $10 the value of our option might decrease by $5.50
In summary, we get more upside, but less downside. This is important in the overall picture. The target Delta we will choose for our options will be 0.70.
Time to expiration
We have to remember that with options we pay for time in the form of the option’s extrinsic value. This extrinsic value component decays to zero as the expiration date approaches. However, the extrinsic value decays more rapidly in the last months to expiration.
For in-the-money options, which we will be selecting for the stock replacement strategy, the decay in the extrinsic value can be visualized by the diagram below.
There are a number of factors to consider as regards time to expiration.
- We want to have options that have long enough to go before expiration so we don’t have to trade in and out all the time.
- Also, we don’t want to be paying too much for time that we don’t need.
- And the last point is that we want to exit or roll our options before the extrinsic value starts to decay significantly.
Putting these points together, the sweet spot is to enter options with between 6 and 7 months to expiration and roll or exit the position when the option has 3 months before expiration.
To determine our approach to position sizing we should consider how we will run our portfolio.
Since we will be rolling out of or exiting options that have 3 months to expiration, it makes sense for us to conduct a monthly review on the third Thursday of the month. With this kind of system, we will not have stop-loss orders. Instead, we rely on taking a long-term view and if we like the long-term relative strength of a sector or a stock, then we will ride out any short-term pullbacks.
All this points to adopting a single position size to manage our risk. To do this by the book, as it were, the position size that we adopt should match in deltas the amount of stock we would otherwise hold if we held an entire position of the underlying stock. This is easiest to see if we put together our entire portfolio. But first here is our rule.
Going back to our list of ETFs and stocks that we said we were going to replace using options, let’s imagine that our portfolio is valued at $100,000. Let’s imagine that we are going to have a total of ten positions in our portfolio and we want them all to be the same size. So each position will be $10,000. Let’s imagine that for our four other positions we choose.
- SPY – the SPDR ETF that tracks the Standard and Poor’s 500 index
- IWM – the iShares ETF that tracks the Russel 2000
- XSVM – the Invesco ETF that tracks the Standard and Poor’s value with momentum
- EDV – the Vanguard Extended Duration Treasury Fund
We would then hold $10,000 positions in each of those four funds. This is how our whole portfolio would be composed.
Disclaimer: nothing written here should be taken as a recommendation to buy or sell any securities. Always consult a professional financial advisor before making any investment decisions and be sure they are right for you.
This is rather interesting. We set out to create a portfolio with ten positions each having exposure of $10,000 to an underlying stock. For simplicity, I have only shown whole numbers of stocks and ETFs but if we really wanted to be exact we could use fractional shares to get those positions to exactly $10,000 each.
We can only buy and sell options in whole numbers so the exposure we get from each position doesn’t come to exactly $10,000 either but nearly.
Let’s walk through a couple of these to see how the options positions work.
In XLF we have four September $32 strike calls which cost $3.40 and have a delta of 0.7041 while the price of the underlying stock is $34.37.
This costs us 4 x 100 x $3.40 = $1,360.00
This gives us 4 x 100 x 0.7041 x $34.37 = $9,679.97 in equivalent exposure to the stock. Which is as near as we can get to $10,000 using whole numbers of options.
In the case of Goldman Sachs, since the option is expensive at $45.86 we can only hold one option and have to accept that this gives us more exposure to the underlying than we would prefer. If we weren’t comfortable with this we could opt to drop this stock and pick another one from the financial sector with a lower stock price and a lower option price.
So for a total commitment of $54,681.24 we have managed to gain exposure to a portfolio of stocks and ETF with a value of $118,924.27. This begs the question, what do we do with the $45,318.76 cash left over?
Well, if our intention is only to have a portfolio that has an exposure to $118,924.27 worth of stock positions, then we should put the $45,318.76 into cash or a mixture of cash and some risk-free store of value such as short-term savings bonds, certificates of deposit or money market funds.
The point is, we need to preserve the value of this cash position. We may need to draw on some of it if any of our option positions incur a temporary setback before we have been able to extract risk from that position. We will see how this works shortly.
When to roll forward
So this is how we manage our portfolio going forward.
Let’s assume that we set up our portfolio around the third week of March. Here is what we do.
On the third Thursday of every month, we review each position in our portfolio. I am picking Thursday so we have time to evaluate and make trades. You can do it all on Friday if you prefer.
If the sector and the stock are still in the top half for long-term relative strength then we keep the position and consider the delta and the expiration date of the option.
If the sector or the stock is in the lower half for long-term relative strength then we replace it with either the top sector or the top stock that we don’t already have. As before we would look for a call option that has 6 to 7 months to expiration with a delta near 0.70.
For those positions that we want to keep if there are four or more months to expiration, then we check the delta. If the delta is less than 0.80 then we do nothing, we keep the position as is. If the delta is greater than 0.80, then we roll diagonally to an option that has 6 to 7 months before expiration and has a delta of 0.70.
For those positions that we want to keep if there are three months to expiration, we roll the option forward to a call option with 6 to 7 months to expiration and a delta of 0.70.
Rinse and repeat.
Here is what that looks like as a flow chart. Here is a PDF of the stock replacement strategy flowchart for download.
And for the sake of completeness, here is our rule.
How many positions
The way we have set up our portfolio, we have six stock replacement positions made up of three broad sector ETFs of the strongest sectors and three of the strongest stocks, one in each of those strongest sectors. I think we can reasonably assume that as long as the market is still on a long-term uptrend we will be able to keep this same number of positions.
If we had set up our portfolio in a less rigid and systematic manner, then we would have to consider how many positions we would want to maintain. But right now, let’s leave that as a hypothetical question for another time.
A month later
Let’s imagine what things might look like a month from now.
Firstly let’s assume that our three sectors are still among the top 50 percent of sectors by long-term relative strength and our three stocks are similarly strong. Let’s imagine a few marginal movements in price of our funds and stock but Ford has jumped to $15. Not at all impossible. Let’s see how that would look
All of our positions still have four or more months to expiration, so no need to change anything for that reason. But our Ford option has gone up from $1.91 to $4.11 and the delta is now 0.9325. What we would do is roll that option diagonally to an October call with a $13 strike price. That would cost $2.69. So when we roll our option position we would receive a net credit of $1.42 or a total of $1,562 cash into our account.
The important point is that our Ford position originally cost $1.91. We just pulled $1.42 out of the position leaving only $0.49 at risk. If a few months down the line we are able to pull more cash out of the position, we will have taken all our original money at risk out.
Of course, things might not go as we hope. Our options positions can lose value and we can be obliged to put more money in when we roll forward once they have less than four months to expiration. That is why we keep a reserve of cash available.
What if we had held the stock?
What if we had held Ford stock instead of the option?
We would have started with 813 shares of Ford at $12.30 each for a total value of $9,999.90. After a month our position would be worth $12,195 so an increase of 22%.
With our option position though we pulled $1,562 cash out of the position. That is a gain of 74% on the $2,101 that we initially put at risk into the position.
You could argue that the 74% gain is misleading as we still held a cash reserve. However, in a general bull market, for my money the stock replacement strategy is a more attractive way to invest, than just straight holding stocks and ETFs.
Questions and answers
Q. How do you know if a stock has options?
A. That depends on your brokerage platform. On most platforms when you select a stock or an ETF, there should be a tab labeled – options. If you click on that tab and nothing is there, then the stock or ETF doesn’t have exchange-traded options. Before you trade the options of a stock or ETF though, you want to be certain that the options are reasonably priced, with acceptable bid/ask spreads and there is enough trading volume. Otherwise, you may have a hard time entering and exiting positions and keeping any profit.
Q. Should you buy deep-in-the-money call options?
A. The stock replacement strategy works best when you buy deep-in-the-money call options.
Q. What is the best stock option strategy?
A. The one that you understand the best, and when best to use, and that you are comfortable with.
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