In the first part of this chapter, we discussed how to use options to completely replicate a position in the underlying security. Another useful option tactic is to use options as a proxy for the underlying.
Generally, this is done when you want more leverage or less risk, or both, than the underlying security itself possesses.
Option Buying as a Short-Term Stock Substitute
In Chapter 1, we dealt with buying calls as a substitute for buying stock or futures. The idea was to use an in-the-money call option for that purpose, for it provides leverage but also is not so subject to the ravages of time decay. The in-the-money option has very little time value premium to begin with.
The same philosophy can be applied to buying short-term, in- the-money puts as a proxy for shorting stock. This has the additional advantages that we described when we discussed fully equivalent positions: the short sale proxy can be obtained without needing an
uptick; and, in the case of common stock, there is no borrowing nec- essary. Moreover, since in-the-money puts generally have even less time value premium than in-the-money calls do, it is usually quite easy to find an in-the-money put that has very little time value pre- mium. In both cases, the in-the-money option will mirror almost all of the short-term movement of the underlying. This is an especially attractive feature for a short-term trader.
Option Buying as a Long-Term Stock Substitute
Short-term traders aren’t the only ones who can benefit from the lim- ited-risk nature of owning a call as opposed to owning the underlying security. Investors with a longer-term viewpoint can avail themselves of this feature as well; they could substitute a long in-the-money call for their long stock. As long-term calls (LEAPS) have become more popular, brokers have been advising investors of the benefits of sell- ing the stock they own and buying LEAPS as a substitute, or buying LEAPS instead of making an initial purchase in a particular common stock. This strategy also increases in popularity during long bullish runs in the stock market.
If an investor sells his stock and buys a call option, he has removed quite a bit of money from the market. He should then take that money and buy a bank certificate of deposit (CD) or a T-bill whose maturity more or less matches the expiration date of the option he purchased. The option gives him upside profit potential, while most of his money is safe in CDs or T-bills. Even if things go terribly awry and the stock collapses and the option expires worth- less, he will still have his money in the bank, plus the interest earned by the CD or T-bill.
The costs to the stock owner who decides to use this strategy are commissions, the time value premium of the call, and the loss of div- idends. The benefits are the interest that can be earned from freeing up a substantial portion of his funds, plus the fact that there is less downside risk in owning the call than in owning the stock. There generally is a net cost of switching; that is, the interest earned won’t completely offset the loss of the dividend, the time premium, and the
commissions. The investor must decide if it is worth that cost in order to have his downside risk limited over the life of the LEAPS options.
The cost to switch may seem like a reasonably small price to pay to remove a lot of downside risk. However, one detriment that might exist is that the underlying common stock might declare an increased dividend or, even worse, a special cash dividend. The LEAPS call owner would not be entitled to that dividend increase—in whatever form—while, obviously, the common stock owner would be. If the company declared a stock split or a stock dividend, it would have no effect on this strategy since the call owner is entitled to a stock split or stock dividend.
There may be other mitigating circumstances involving tax consid- erations. If the stock is currently a profitable investment, the sale would generate a capital gain, and taxes might be owed. If the stock is cur- rently being held at a loss, the purchase of the call would constitute a wash sale, and the loss could not be taken at the current time.
Using LEAPS Puts instead of Calls
In the preceding strategy, the stock owner paid some cost in order to limit the risk of his stock ownership to a fixed price. He might be able to accomplish the same thing at a lower cost to himself. If he buys a LEAPS put against the stock that he owns, he has a position that is equivalentto owning a LEAPS call. He would still have upside profit potential (now in the form of long stock), he would have downside protection (provided by the long put), he would have spent less in commissions (only the commission for the put), and he might not dis- turb the tax holding period of his stock.
The comparison between substituting a call or buying a put is a relatively simple one. Merely compare the cost of switching with the cost of the put. If arbitrageurs are doing their job, the put will most likely be the better way to go. Moreover, capital gains don’t have to be realized with this method. The purchase of a put may suspend his holding period for tax purposes (if he is not already a long-term holder), but the LEAPS call strategy had its own tax complications.
Moreover, he would remain fully represented for all dividends since he continues to own the common stock.
Whether the strategist uses the put or the call, if the underlying stock rises in value, he will want to sell the LEAPS option he owns and buy another one with a higher strike, in order to further protect the profits that build up as the stock rises.
In my opinion, the purchase of a LEAPS put is a more efficient way to protect long stock. However, the former strategy—selling the stock and replacing it with a long call—is usually preferred by broker- age firms.