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Nervous About a Market Pull Back? How to Take Some Chips Off the Table - By OptionsHouse

Many investors seem increasingly nervous about the market's prospects. Just when traders felt that any more upside was limited due to the fact that the major indexes seemed stuck in a downward funk, with 3 straight down weeks, the Bulls enjoyed a sudden 1.3% rally on Wednesday this past week. Just as quickly, Friday morning's weakness is putting fear back into the equation.

Option Trade Chart

Longs are nervous; shorts are disappointed they might be missing out on the beginning of another leg higher in the market. So what can you do if you have enjoyed a bullish market ride higher, being generally long the market the past several years, but now you are starting to have doubts about further upside? This is the million dollar question right? You can't afford to miss out on further gains, trying to time the market has been proven to be next to impossible…

One option you may consider is what winning poker players sometimes refer to as taking some chips off the table: essentially staying in the game but with a little less risk than being all in all the time. I will outline a basic option strategy called the Stock Replacement strategy which may fit with how many active investors are feeling today.

First the basics:

The risk to a long stock position is the share price may fall - theoretically, it could fall to zero so the entire purchase price is really at risk. The risk to a long call option position is also the entire purchase price, 100% of the premium paid for the call if the stock share price is below the strike price at expiration. This premium for the option is usually a fraction of the full stock price. This is why the strategy is also known in institutional trading circles as Cash Replacement or Cash Extraction strategies because you are taking cash out of the market and off the table.

Here's how using stock replacement works in taking some "chips" off the table. Remember you want to remain in the market and especially if you believe the market will continue its long term trend higher, so you replace a long stock position (you sell your long stock) with a long call option position (you buy to open a new call option position). A call option gives the owner the right to buy the stock at a predetermined price (strike price) until a pre-determined time (expiration date), so if the actual price of the stock increases, theoretically, the right held by the option will increase in price. You may have tax consequences when you sell your profitable long stock realizing your gains, but there are worse things than having to pay taxes - not having to pay taxes for example.

Now the specifics:

Using the option's delta is the key to determining the proper strike price for the option. Even if you don't know the first thing about the Option Greeks, you can use what they tell you for this strategy. Delta is a measure of the percentage of price risk that an option has relative to the price risk a stock ownership has. The delta of the call will indicate the amount of risk you will have relative to a 100 share long stock position. Obviously, a long stock position experiences dollar for dollar profit or loss relative to the price movement of that same share of stock. A 70 delta call option however, theoretically moves in price at 70% of the movement of the underlying share price. If the stock rises $1, a 70 delta call option should increase in market value by 70 cents. Remember, deltas and all the Greeks are theoretical measures. The financial models from which they are derived assume that factors such as implied volatility of the options, interest rates and even time are all unchanged and the only actual change is the underlying stock price when calculating delta. Likewise, if the price of the underlying stock or ETF falls $1, the 70 delta again implies that the market value of the call option will only fall 70 cents. So quite simply, replacing a long stock position with a 70 delta call will result in 70% of the risk associated with the ownership of stock. You have taken 30% of the risk of stock ownership "off the table."

There is an added benefit of this as well as a cost associated with this strategy which is best explained using a real life example.

The SPDR S&P 500 ETF has enjoyed a remarkable 2 year run, rising 31% in price return from 160 to over 210 (even more in total returns when factoring in dividends). If you have been wise enough to have remained long the overall market great for you!

Option Trade Chart

YTD however you have only seen modest rise of 2.5% in the SPY. So is not the time to use the Stock Replacement Strategy to take some exposure off the table? If you have a 500 share position in the SPY ETF, you have $105,000 of risk in this position. It doesn't matter that your cost basis may only be 160/share your current risk is what is important. You could replace your long stock with a long in the money December 198 strike call option.

Option Trade Chart

This is a 70 delta call option with a premium for 1 contract controlling 100 shares of around $17. So to replace 500 shares of long stock exposure, we want to buy 5 contracts totaling $8,500 in total premium. (5 X $17 X 100 = $8,500). So immediately after you sell your stock for $210.36 x 500 shares you extract $105,180 from your stock sale proceeds and pay $8,500 for the long call option you net $96,680 in cash. It is important to note that examples do not take into consideration commissions and other possible trading or exchange fees.

That's all great, but increasing the cash in your account is only one of the benefits of this strategy and not the point of this blog. We want to pull some chips (risk) off the table. By buying this call we reduce our absolute risk to that of the premium paid $8,500 from long stock of $105,000! Immediately our risk profile will more closely represent that 70 delta (percent) we referred to. For each dollar move in SPY up or down we should theoretically make or lose about 70 cents. Further, the delta of this option is not static. As the price of SPY shares rises, the delta will increase toward 100 and subsequent price moves will mirror that of the stock at 100%. Should the stock fall, the delta will decrease toward zero eventually - remember, you can't lose more than 100% of the option premium you paid no matter how low the market and the SPY stock price might fall. If, for example, the SPY fell 15% to $179 a stock holder would lose 31.55 points or $15,700. Those holding the option cannot lose more than what they pay = $8,500 and never more!

These benefits are not free. The $17 this option costs has additional time value or extrinsic value relative to the stock price. The stock is trading $210.36, and the option has a strike price of $197. Subtract the strike price from the stock price $210.36 - $197 we get $13.36 of parity value. The extra premium of $3.64 that this option cost is the extrinsic value. The stock must appreciate 3.64 or 1.73% in order for this option to be profitable. Also you need to consider that long call options are not entitled to the dividends paid by the stock or ETF. SPY pays about $1 a quarter in dividends and there will be 3 payments between now and December expiration. This is an added cost to owning calls instead of the stock itself. Remember, you can always sell out of the call option prior to an ex-dividend date and buy back the stock should you desire. Or, as we approach expiration in December, you can exercise your call option right and buy the stock at the strike price.

Again, this is not a buy, sell or hold recommendation, but simply an example of how stock investors can use the stock replacement strategy to take some chips off the table on an individual stock position. It allows you to remain with positive exposure to market gains but in a more risk managed and hedged fashion.

Best of luck in your trading!

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