Reduce individual stocks allocation by switching to call options

ironchef · Nov 2, 2019

spindr0 said:
Using a high delta call LEAP as a surrogate for the underlying is called a Stock Replacement Strategy. Assuming that the implied volatility is reasonable, because the call is deep ITM, you'll pay a modest amount of time premium and you'll have very little time decay (theta) in the early months, even longer if it's a two year LEAP.

The call LEAP will lag the underlying not only by the amount time premium paid but by the dividend as well (if any) which goes to the share owner. It's not because the dividend is a profit to the shareholder but because the LEAP's price drops by the amount of the dividend going into the ex-div date.

In return, you will lose less on the call LEAP if the underlying collapses. On an expiration basis, below the strike price the shareholder continues to lose whereas the LEAP owner loses nothing beyond the premium.

Prior to expiration, as the stock drops, the delta of the call will drop which means that the call LEAP will lose less than the stock for each dollar of underlying drop. How much? It depends on the size of the drop, when the drop occurs, and what the implied volatility is at that later date. Suffice it to say, the call LEAP will lose less.

A benefit of LEAP ownership is that if the underlying rises nicely, you can roll your call up, pulling money off the table and maintaining your risk level, something you can't do with long stock. You'll give up some delta but you'll repatriate some principal, lowering your cost basis.

If you have an upside target price where you'd be willing to sell, you could sell a nearer term call against your call LEAP, creating a diagonal spread. The credit received would offset some of the time premium paid for the call LEAP. If it expires, wash, rinse, repeat. This is often called the Poor Man's Covered Call.
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Great post. Just to add a couple of comments, you always trade off long calls vs buying stocks on margins, trading off theta decay..., vs margin interest carrying cost. It is also not that obvious trading expiry time vs premium. In my simulations, longer dated options had inferior return than shorter dated options. There seemed to be a sweet spot that were different with different underlying.

MM are getting smarter, IV for long dated options nowadays for individual equities often are higher at longer expiry making long dated options more expensive.

spindr0 · Nov 3, 2019

lindq said:
Flip your strategy. Keep your stocks, and buy index futures as a replacement for tying up funds in index funds.

Options strategies as a replacement for underlying equities will ALWAYS carry additional costs and hassles.
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Granted, I don't know squat about futures but how does buying index futures facilitate the OP's goal of reducing his concentration risk in a few stocks and transitioning into diversified ETFs?

It's true that options USUALLY carry additional costs but it's not ALWAYS. A no cost collar offers profit potential while laying off a large part of the risk. And when there are costs, the big picture is that laying off that risk may make option those costs acceptable.

spindr0 · Nov 3, 2019

ironchef said:
MM are getting smarter, IV for long dated options nowadays for individual equities often are higher at longer expiry making long dated options more expensive.
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I can't source it but I agree with you that long dated options more expensive now. When LEAPs were introduced nearly 30 years ago, they were far more attractive for diagonal spreads. It took fewer months of writing to recover the time premium paid for the LEAP.

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Reduce individual stocks allocation by switching to call options

ironchef

spindr0

spindr0