A stock replacement with benefits
A frequent question that is asked about option is whether or not it makes sense to use them as stock replacement, i.e. not to trade volatility or to benefit from option’s time decay but simply to express a directional view on the underlying.
The answer is definitely positive for one simple reason: buying an option will guarantee that your max loss is the premium you paid.
If you are not familiar with options or simply want to know more about option trading and how to manage option strategies, please visit the Option Strategist section by clicking the link below.
There is no other way to cap your losses. For example, the widely used stop losses are not guaranteed to be executed at the desired price. If, for example, the market gaps down and below your stop loss, your long position will lose more than what you thought you might lose at your stop loss level.
So, if you expect a stock or index to go up, buying a call would give you the positive delta you need and will have a max loss limited to the premium you paid to enter. Similarly, if you expect a stock or index to go down, buying a put would give you the negative delta you need with, again, the max loss limited to the premium you paid.
The option premium is made of 2 components: the intrinsic value and the time value. The first component is easy to understand since, for a call, it is the difference between the current underlying price and the strike price, or viceversa in case of a put option.
The time value, instead, is the additional price that the market is willing to pay on top of the intrinsic value for that specific option. This amount is mostly affected by the residual time to expiry and implied volatility. As such, any time value we pay when we buy an option will be lost by the time the option expires. This is why many people consider option selling as an income strategy, since there are strategies designed to bank the time value of sold options that we hope will expire out-of-the-money.
Let’s look at the option chain below for SPY. The put 450 has a time value of 2.51 while the put 445 has a time value 5.07. Given that the 450 is more in-the-money than the 445, the latter will have a higher time value while the former will have a premium that is mostly made of intrinsic value.
By definition, out-of-the-money options don’t have any intrinsic value so the premium we pay is purely time value.
Now, let’s say that we are bearish on SPY and want to buy a put to express our view. A put strike 455 has a delta of about 0.84 so this option will behave like a short position on 84 units of SPY. In the image below, the left panel shows the corresponding payoff and if you look at the table under the plot, you can see that if market doesn’t move, this position will lose about 110 USD.
Even if this option is in-the-money, the premium will still have some time value and if market doesn’t move this value will be lost, hence the 110 USD loss we see.
How can we achieve the same negative delta (here about 84) without having to pay much time value? To do that we can refer to the option chain we saw earlier, where we can see that the time value we pay on the 450 can be offset by the time value we get by selling the 445. So we can buy 2 puts strike 450 (total delta is about 1.4) and sell 1 put strike 445(delta is 0.54). The overall time value is almost zero and the overall delta is about 0.85, so we can get a delta that is similar to the single leg strategy we saw before. This is illustrated on the right hand side.
But now let’s look at the table below the plot on the right hand side. The fact that we built the strategy to offset the time values means that if market doesn’t move, we won’t lose anything, since there is no time value that could be lost.
So we have a possible replacement for a short position on about 85 units of SPY without having to pay any time value. Additionally, if you look also at the max loss of the 2 strategies, you can see that the second one has a better risk/reward profile.
The obvious drawback of this approach is that the strategy involves 2 legs (3 options in total) while the original put strategy has just one leg. But with liquid options this is not a problem and the slightly more commissions and bid/ask you pay are more than compensated by the various benefits that this strategy offers.
From a trade management perspective, it is advisable to close the position few days before expiry. In the last few days the gamma of the second strategy is higher if the underlying has moved up 1%. This can easily be seen from the change in deltas in that region: while the single put has a delta that goes from -1 to 0 (on expiry date), the second strategy has a small region where the delta is -2 (because we are long 2 puts while one has expired worthless). So, about 3/5 days to expiry, this is the time where the gamma profile of the second strategy changes compared to the single put trade, so better to close and reposition.
To summarise, using options for directional trading has the benefit of being a defined risk strategy in any scenario. This is thanks to the optionality that these instruments grant. The price we pay for this benefit is the time value, so finding a way to limit or completely offset this makes options a real “stock replacement with benefits”.
This strategy can be used on the markets we trade. If interested in current Trading Mate’s exposures, please click on the link below.