Stock replacement in the spotlight

abnormalreturns
November 2nd, 2006

*This post originally appeared as a part of the Blog Spotlight series over at the Big Picture. Thanks again to Barry Ritholtz for the opportunity.

Seldom a day goes by without the financial press reporting on some new financial product innovation. We have been attuned to the fact that with this increase in choice also comes a need for education and proper context. While ETFs are clearly the most visible, the list does not end there. Option volumes have also surged showing an increasing interest on the part of investors to more closely match their viewpoint with the best financial instrument.

We here at Abnormal Returns do not claim to be options experts, but the time is right to explore an interesting options-related opportunity. The stock market, measured by the S&P 500, has run up from a June low of some 1220 to a recent high of nearly 1390, for a gain of some 14%. With some valuation and technical measures becoming a bit overextended it should not come as surprise that some investors are looking to reduce their overall market exposure.

It just so happens the stock market is providing us with just such an opportunity. During this stock market rally implied volatilities have fallen back to the lowest levels of the year. For example the VIX is hovering right around 11% at the time of this post. This low volatility allows for what are best described as ‘stock replacement’ strategies. This involves selling appreciated stock and replacing it with an equivalent call position. The long call position would be calibrated such that it provides roughly the same exposure as the original stock position.

This serves two purposes. First you can maintain the original long stock exposure, with the assumption being that it remains an attractive one. However you have locked in the gain on the stock. Second, holding calls reduces the downside risk from continuing to hold the original stock position. If the stock declines, the call position can obviously not drop farther than the premium paid.

The currently low volatilities allow investors to do this for a relatively low cost. If implied volatilities were high, this strategy becomes cost prohibitive. In short, you would be paying much more for the implied downside protection. While we are discussing individual stocks, the same strategy could be used for index-like positions as well. With the increasing number of ETFs that have listed options the opportunity to use options strategies is increasing.

Why not sell out the stock altogether? A couple of reasons. The first being presumably you own the stock for some sound fundamental reason. Even in an overpriced market there presumably are attractively priced stocks. Second, unless you are a hard-core market timer, eliminating stock positions in their entirety is a large bet that the market will drop dramatically. A stock replacement strategy has the advantage of being a middle ground. You continue to have long stock exposure, but the risk of a dramatic drop is offset by the nature of the underlying calls.

As an aside, if this talk of options, specifically implied volatility and calls is confusing to you then you should stop right here. You should feel comfortable with the mechanics of options pricing and trading before considering any sort of options-related strategy. While options pricing isn’t rocket science it does require a thorough understanding before proceeding.

No strategy, including a stock replacement strategy is perfect. First off it requires additional trading including commissions and bid-ask spread. Second, if you hold the original position in a taxable account, presumably the stock sale would incur capital gains taxes. Third, this strategy is not a risk enhancing strategy. Properly used it should help mitigate risk, not be used to ladle on additional market exposure. Fourth and maybe most importantly, there is the risk that the calls simply lose value over time if a stock and/or the market remains range bound.

By no means should this post serve as your sole source of information on stock replacement strategies. Adam Warner at the Daily Options Report has covered the topic of low implied volatilities and stock replacement strategies on more that one occasion. This post serves as a good primer on stock replacement and begs the question why more market pundits don’t comment on the strategy. Pat Dorsey at Morningstar.com takes a different approach, but comes to much the same conclusion. Dorsey focuses on the use of longer term options (LEAPs) as a piece of a stock replacement strategy. In the article he also includes data on some of Morningstar’s most attractive large cap stocks with low implied volatilities.

As stated earlier, we make no claim to any great options expertise, but a stock replacement strategy is pretty intuitive. Competition and innovation have helped created a marketplace in financial instruments that make strategies like this feasible and not cost prohibitive. With this greater investment flexibility comes a need for a commensurate amount of investor responsibility. As a self-directed investor you should feel comfortable both with the investment case for the underlying stock or ETF, and the pricing and mechanics of any options used before implementing any strategy, let alone a stock replacement strategy.