Another edition of our new series: Blog Spotlight.
We put together a short list of excellent but somewhat overlooked
blog that deserves a greater audience. Expect to see a post from a
different featured blogger here every Tuesday and Thursday evening,
Up next in our Blogger Spotlight: Abnormal Returns. AR is a year old blog written by a private investor with
nearly two decades of experience in the markets. His experience
includes a stint in a variety of roles with a mainstream investment
management organization, extensive publications in the practitioner
literature, and a hedge fund start-up. The Abnormal Returns blog is
focused on investor education and unearthing items of interest for the
Today’s focus commentary looks at Stock Replacement Strategies in the Spotlight
Replacement Strategies in the Spotlight
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 innovation, 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
most appropriate financial instrument.
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
measures becoming a bit overextended it should not come as surprise that some
investors are looking to reduce their overall market exposure.
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.
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
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.
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.
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.
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
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
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
Category: Blog Spotlight
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