IBM: A Case Study on Replacing Stock With Call Options

| About: International Business (IBM)

By Richard Bloch

In a previous post on IBM, I explained the company’s plan for boosting its earnings into 2015 and noted that a friend of mine who has worked there for many years has built up a large position in the stock.

His dilemma? He wants to stay bullish on his employer, but he may have too much stock in one single company from the perspective of a balanced portfolio.

It’s certainly not uncommon for employees to end up with large stock positions in the companies they work for, but it can be risky to have too much of your portfolio in just one stock – even a blue chip company like IBM.

Let’s say my friend has worked at IBM for around 15 years or so, took advantage of the opportunity to acquire stock every month, and now has 2,000 shares at a cost basis of $80 per share ($160,000 total). As of January 28, those hypothetical 2,000 shares were worth around $318,000. For anyone who isn’t a multi-millionaire, that’s a lopsided position for just one holding. So how can he reduce his risk and take advantage of any potential appreciation?

One way would be to use a stock replacement strategy. That involves selling existing stock and replacing it with a similar quantity of call options.

I took a look at the January 2013 call options that expire in a little under two years. That may seem like a long time, but remember that options do expire – unlike stock, which doesn’t expire. Plus, these options aren’t all that liquid and have wide bid-ask spreads, but my friend would probably want a simple strategy that doesn’t involve rolling over options every few months.

Sample stock replacement strategy

For example, the January 2013 120 calls cost $42.45 when the stock was trading at $159.21, so the calls cost a few dollars more than their intrinsic value of $39.21 (stock price of $159.21 less the 120 strike price).

So perhaps my friend could sell his 2,000 shares of stock and buy 20 of these call options, which would give him the right to be long 2,000 shares of the stock, at a price of $120, anytime before expiration. Accounting for commissions, that transaction would look like this:

Sell 2,000 shares of IBM at $159.21 $318,415
Buy 20 January 2013 120 calls at $42.45 $84,915
Net credit $233,500

Regardless of what happens to IBM’s stock, my friend keeps the $233,500 he collects, which he can just leave in his account as cash.

Now here’s what the position would look like at expiration in 2013, accounting for commissions:

The dashed green line shows the value of the stock if my friend had simply held onto it. The blue line represents the value of the options plus the cash he collected. The “floor” on the position is essentially the cash collected in the transaction, because that’s not at risk.

Just to clarify that point: The smaller chart at the bottom shows that the options themselves won’t be worth anything unless IBM is above 120 at expiration.

Note that the position eliminates a lot of downside risk, but offers almost the same upside potential if IBM rises. At levels appreciably above 120, holding onto the stock would have worked out better, but only by about $6,500 or so.

Collect more cash, sacrifice some upside potential

Here’s another approach. With the stock trading at $159.21, the January 160 calls have no intrinsic value, but cost less overall than the 120 calls in the previous example. So replacing 2,000 shares of stock with 20 of the 160 calls would look like this:

Sell 2000 shares of IBM at $159.21 $318,415
Buy 20 January 2013 160 calls at $16.15 $32,315
Net credit $286,100

With this strategy, my friend could take more money out of his position – $52,000 more than in the previous example. And here’s what that position would look like at expiration, after accounting for commissions:

Collecting the extra cash by paying less for higher strike options comes at a cost. There’s less potential appreciation because the call options won’t be worth anything unless the stock is higher than $160.

Also note that the blue line is well below the dashed green line even at stock prices where the calls would have value. Towards the right of the chart, the difference is about $32,000 and reflects the cost of buying options that had no intrinsic value when purchased.

Potential pitfalls

Which strategy is best? That depends on how much risk one wants to “take off the table,” so to speak. The second approach collects more money, but at the cost of giving up some potential gains.

And it could be that neither of these strategies – or even stock replacement at all – is the best approach when considering some of the potential pitfalls of replacing stock with options:

  • Poor liquidity: Most of these long-term options have bid/ask spreads measured in dollars, not pennies, with the best published bids often below intrinsic value.
  • Tax implications: Selling stock could mean recognizing a taxable gain – and option gains or losses can be taxed differently than stock (consult a tax advisor for details).
  • No dividend: Owning call options doesn’t mean you’re a shareholder. You don’t receive any dividends and get no vote on shareholder issues.
  • Extra commissions: Selling some of the call options at different times increases transaction costs compared to simply holding the stock.
  • Time decay: All other things being equal, time decay will erode the value of call options – especially those that are out of the money.
  • Potential loss: Options eventually expire, of course, which would mean a full loss of all option premium paid.

Some may wonder why I wouldn’t sell some higher strike call options to help pay for the calls being purchased – or simply sell calls against the stock itself (note that complex option strategies will increase costs due to multiple commission charges). Others may consider those illiquid longer-term options are poor trading vehicles. To some extent, I’d agree with all of these points – and they may be good ideas for active traders.

But I’m just trying to keep things simple – to help a friend who is not an active trader understand how he might “right size” his exposure to a stock in a way that protects some gains and maintain a bullish bias on the company he works for.