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Buying Call Options as a Means of Stock Replacement

Filed Under Beginner Options Trading 

On the other hand, an option with a much lower delta, say 0.50, has a lot of time premium and therefore behaves more like an option rather than stock. When we say “behaves like an option,” we really mean that it doesn’t respond too systematically with the stock. Its price can also be greatly affected by time decay as well as volatility. The important point is that you want to initially purchase an option that behaves much more like the stock.
 
 
If you are buying call options as a means of stock replacement, then buy relatively high deltas in the 0.80 to 0.85 range.
 
Now that we’ve located the proper strike ($75), we simply place the following order:
 
Buy to open, two April $75 calls, symbol IBMDO, at market (or limit)
 
Of course, you could place a “limit order” rather than a “market” order to assure the price, but then you cannot guarantee that the order will fill. By placing a market order, we are allowing some price fluctuations while the order is being routed but are also guaranteed to get the order filled.
 
Once the order is filled, we are effectively controlling 200 shares of stock for up to the next 230 days. We do not need to remain in the contract for the full term as we can certainly exit the contract at any time by selling it.
 
Assume that the order is filled for the $8.30 asking price. Your account will be debited 200 * $8.30 = $1,660 plus commissions. Notice that it was going to cost you nearly $16,000 to buy 200 shares of stock, but you can effectively control those same shares for only $1,660. And it is this difference in prices that represents the protection you get from call options, since the most you can lose with the call is $1,660. Figure 8-2 shows the profit and loss curve for our two IBM April $75 calls:
 
Figure 8-2
 

Figure 8-2

Notice the flat part of the profit and loss curve to the left of the $75 strike. This shows that our maximum loss is defined and that is the absolute most we can lose. In other words, the call option provides protection. For example, assume that IBM has a bad earnings report and the stock plummets down more than 30% to $55, down $24.46. The stock trader is down 200 shares * 24.46 = $4,892. The option trader is down only $1,660. If the stock price continues to fall, the stock trader continues to lose money while the option trader’s losses are capped at $1,660. The option trader’s maximum loss is 100% defined the second the trade is placed.
 
There may be those investors who believe this is an unrealistic comparison because they would never allow this type of loss to happen to them because they use stop orders. But as our discussion in Chapter Four showed, stop orders do not prevent losses. In most cases, stop orders can work reasonably well but the point is that they are not guaranteed to limit you to a fixed amount of loss. Call options will. In this example, the call trader is 100% certain that the maximum loss is $1,660 while the stock trader cannot make any such claim.
 
Another reason that options provide better protection than stop orders is that stop orders are “path dependent” while options are “time dependent.” This simply means that the performance of a stop order depends on the “path” the stock takes. While it is possible for a stop to protect you, it is equally likely that it may force you to sell too early. For instance, assume you have the previous 200 shares of IBM and place an order to sell your shares at a stop price of $78. The stock might take the path of falling to $78 – thus forcing you to sell your shares – and then immediately turn around and climb much higher. In this instance, the stop order did prevent you from losing but it also forced you to miss future gains because of the particular path the stock took. Had you been holding the $75 call however, you never would be “triggered” out of the position just because of the path of the stock. Instead, by holding the call, you are locked into the $75 buy price over a period of time. Only if the stock’s price rises after the call option expires will you miss out on future gains. In other words, you are constrained by time, which is why we say that options offer protection that is time dependent while stop orders offer protection that is path dependent. Unfortunately, most of the major losses in stocks come after the close and there is nothing you can do with a stop order but wait for the opening price. Stop orders are not an equal substitute for options.
 
In order to be fair with our comparisons, isn’t it possible that our call option could expire worthless at expiration but then the stock could rise thus making the stock trader better off? That’s true, but in many cases the call buyer has the ability to buy the stock at the lower market price. For example, let’s go back to the beginning when we were deciding on whether or not to buy the stock. At that time IBM was trading for $79.46 and the April $75 call was trading for $8.30. If you have $79.46 available per share to buy the stock but decide to only spend $8.30 to buy the call then you have $79.46 - $8.30 = $71.16 in cash that can earn interest. Now let’s assume that the stock price falls to $70, which makes your call option expire worthless at expiration. It appears that the stock owner is better off because at least he has shares that might rise in the future while you have lost 100% of your investment with the $75 call. However, if you are still bullish on the stock at that time, you can buy the shares at $70 market price out of the $71.16 that you have sitting in cash.
 
The $71.16 price is the crossover point between the two strategies of buying 200 shares of stock versus buying two April $75 calls as shown in Figure 8-3:
 
Figure 8-3: Comparison Between Long Stock and Long $75 Calls

Figure 8-3

 
 
If the stock’s price is below $71.16 at expiration then you will have enough money sitting in cash to buy the shares of stock if you wish. However, if the stock’s price is above $71.16 then you will not have enough money to buy the shares unless you contribute more money. We could increase this $71.16 number a bit if we wanted to include the interest you could have earned on the cash but that will probably be negligible. The point is that the stock trader is not necessarily better off just because the call option trader lost on the option. The option trader can always elect to buy the shares in the open market at the lower market price.
 
If the stock’s price is above $71.16 at expiration, the option trader will underperform the stock trader as shown in Figure 8-3; that’s why the stock line lies above the call option line. The reason is that the call buyer must pay a time premium for the $75 call and that money is gone for good at expiration. The time premium is the cost of losing less money for all stock prices below $71.16. In this example, the $75 call has $3.84 worth of time premium and that can never be recovered. It is the true cost of being able to always buy shares for $75.
 
For example, assume the stock is $85 at expiration. The stock trader makes a profit of $85 - $79.46 = $5.54. With the stock at $85, the $75 call is worth exactly $10, which means the option trader makes a profit of $10 - $8.30 = $1.70. Notice that the difference in their profits is $5.54 - $1.70 = $3.84, which is exactly the amount of the time premium in the $75 call. Pick any expiration stock price above the $75 strike and you’ll find that the stock trader’s profits are exactly $3.84 larger than the option traders. This can be seen by plotting the $75 call option’s profit and loss diagram against that of the long stock position as shown in Figure 8-4:
 
Figure 8-4

Figure 8-4

 
In Chapter Five, the put-call parity formula showed us that if you were absolutely certain that a stock was going to rise that you should either buy the shares with borrowed funds or buy the call and sell the put. Figure 8-4 shows why. The reason is that the long call buyer will always underperform the long stock buyer by the amount of the time premium for all regions above the strike price. Notice that above the $75 stock price, the two profit and loss curves run parallel to each other. Those two lines will never meet at any higher stock price and that’s a way of showing that the long call buyer will never get the time premium back. However, since we don’t know for sure whether a stock will rise, the call option provides a lot of protection by removing all of the downside risk that we showed in Figure 8-3. The time premium is the cost of that protection.

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