Investing Adventures

We’ve started with an introduction to the stock replacement strategy and we’ve gone over the plan. Here’s a recap of the plan:

1. Purchase deep in the money calls for a high momentum stock as its delta is close to 1, resulting in an almost 1:1 movement in call value to stock price
2. Short common stock against the long calls as a protective put and for income
3. Sell near or at the money calls (especially close to some sort of event) for income. Near or at the money calls lose a bit of energy as the stock price rises since its delta begins to approach 1

Let’s go ahead and recap the example portfolio we’ve set up for this strategy:

Long 10 GOOG Mar 610 Call @ 95.4

Short 50 GOOG Common @ $673

Short 5 GOOG Nov 680 Call @ $19

So what do we have set up? We have approximately 450 shares in our control of Google for appreciation. Now, let’s see how the cycle works.

Let’s first assume Google rises in value. Since it’s difficult to place actual values on the calls, let’s just go with a general increase/decrease description (you could use the options calculator at ivolatility.com for more accurate results). Assuming Google increases in value, what happens to each portion of the portfolio?

Long 10 GOOG Mar 610 Call @ 95.4 – Increase in value on a 1:1 scale

Short 50 GOOG Common @ $673 – Decrease in value on a 1:1 scale

Short 5 GOOG Nov 680 Call @ $19 – Decrease in value approaching a 1:1 scale

What we’re left with is an increase in the long calls with a decrease in value from the shorted common and calls resulting in a net increase of approximately 400-450 shares of Google. For every 10 points Google rises, your profits increase by approximately $4,000 – $4,500. It’s not as great of a profit had you bought the long calls outright, but in terms of a low risk / medium reward I think it’s worth it. With a high flier such as Google, we could easily see $700+ in the next few months which would translate into a gain of about $12,000 on a net investment of $52,500, or 22%. I know, the profits could have been bigger, but at least you’re able to sleep well at night if Google’s stock goes down, right?

What happens if Google’s stock begins to fall (for whatever odd reason… maybe the solar panels at Googleplex explode for example…)? Flip the above results. The net result would be a loss of approximately $4,000 – $4,500 per 10 points of downside.

So what’s so great about this strategy?

Obviously, you need to have conviction and discipline. Google is a fundamentally sound company with growth, but every stock has a down day. Assuming Google increases in value, according to this theory, you need to begin shorting more and more Google stock.

Wouldn’t shorting more Google stock lower your profits from the long calls?

Yes, until Google has a down day. Let’s assume you’ve set a shorting timetable for your stock (in this case Google). For every 5 points your stock rises, you plan on shorting X shares. For our example, let’s assume every 5 points translates to 50 shorted shares of Google. At $678, 683, 687, etc., you would go ahead and short 50 shares. According to Cramer’s strategy, you should short about 25% of the controlled shares in your long calls, i.e. for every contract you’re long your maximum common short limit is 25. In our case, we’re limited to 250 shorted common of Google.

Let’s assume you’re at full shorting capacity using our example of 50 every 5 points. This would give you a short of 250 common shares of Google at a cost basis of $683 with a current price of $693. Let’s say tomorrow Google (along with the rest of the market) begins to nose dive. Suddenly the price of Google is at $673, back to where you started. As the price of Google begins to decrease, you begin to cover your short. This is how the stock replacement strategy generates cash. You short common on the way up and cover on the way down while the deep in the money calls provide protection and the shorted calls provide additional firepower.

From what I gather, stock replacement can be a pretty powerful strategy. You need to set your base up with the deep in the money calls and then offset the cost through shorting common and calls. As the price of your stock fluctuates, you short and cover the common stock generating income while the time decay on the shorted calls takes hold. The best case scenario sees the shorted calls expire without assignment while you’re constantly shorting and covering shares for income. All of this, of course, is being protected by your deep in the money long calls.

What’s the worst case scenario? The stock could retreat to your deep in the money strike price. The loss from the call value is offset somewhat by the shorted common and shorted call (which is probably worthless in terms of value). However, since your long calls are deep in the money, any number of strategies can be employed to protect your position such as rolling down and/or forward if need be.

Stock replacement appears to be a great tool at generating a modest amount of income while still having long term upside exposure to a stock with a relatively good momentum upward. The only issues I see with this strategy are a) it may require a larger amount of capital than some starting investors may have and b) the margin maintenance requirements for the shorted common may be quite large.

In summary, here’s what the strategy requires:

• Purchase deep in the money calls on a momentum stock
• Short common stock (preferably on  a scale as you would going long, up to 25% of the controlled shares from the long calls
• Short at or near the money calls for extra premiums.  May be preferred to short calls near a major event for extra premium due to increased volatility.  Short calls on a 1:2 ratio, that is for every short, make sure you have 2 long positions

With whatever strategy you use, good luck and be careful. The markets have been extremely rough as of late! Don’t let the market humble you! You should be humbling yourself!

*Thanks to Jim Cramer and James Altucher for bringing this subject up and piquing my curiosity. You two, along with TheStreet.com, are great!

From the introduction, here’s the current status of the example stock replacement strategy:

Long 10 x GOOG Mar 610 Call @ 95.4 = $95,400

The second phase of this strategy involves shorting common stock against the long calls. The calls act as protection against your shorted common. This effectively creates a put against your calls. So how would this work in the money making cycle? I sat around for a bit thinking about how it worked. Using Google again, let’s go ahead and short 50 shares at the current price of $673. Now our example strategy shows the following

Long 10 GOOG Mar 610 Call @ 95.4

Short 50 GOOG Common @ $673 = $33,650

Here’s where the cycle begins. As the price of Google increases, the call value should increase on an almost 1:1 scale while the shorted common begins to depreciate in value. Here’s what our model portfolio would look like assuming Google increases $20 in value:

Long 10 GOOG Mar 10 @ ~115.4 (from 95.4)

Short 50 GOOG @ $693 (from $673)

The total profits from the increase in value are approximately $20,000 from the increase in call valuation minus $1,000 from the short common depreciation, giving you a net profit of $19,000.

Not a bad trade… not bad at all.

As the price of Google drops, the shorted common increases in value while the long calls decrease in value. This strategy limits your downside risk depending on the amount of shorted common you have against your long calls. Assuming Google drops $20, here’s what our example shows:

Long 10 GOOG Mar 610 @ ~75.4 (from 95.4)

Short 50 GOOG @ $653 (from $673)

Total losses in this case would be $20,000 from the long calls – $1,000 from the appreciation from the shorted common, giving you a net loss of $19,000.

Awful… just awful.

This is where phase three of the strategy comes in. According to Cramer, with a high momentum stock, it’s possible to increase income through long calls, shorting common, and shorting calls near the stock price in the current expiration month.

A-ha! Shorting calls! That’s the bond that ties the strategy together.

Taking Google once again, let’s look at what the $670 and $680 strike prices are going for in November 2007.

The GOOG Nov 670 Calls are going for approximately $24 while the Nov 680 Calls are going for approximately $19. The key to shorting these calls is that, on a high flying stock, as I understand options the deeper an option goes into the money, the less “punch” the option has since it’s delta begins to approach 1. It’s that initial punch that we want to capitalize on. Let’s take the $680 calls for this example. The key is to short half of your long calls. For the sake of simplicity, let’s short 5 Nov $680 calls all at once. In reality, I would assume you’d short the calls on a staggered basis depending on an increase in implied volatility as a result of some event but for now let’s load up the lot all at once.

Long 10 GOOG Mar 610 Call @ 95.4

Short 50 GOOG Common @ $673

Short 5 GOOG Nov 680 Call @ $19 = $9,500

This strategy effectively creates a debit spread with a simulated put protected by the long calls. See what I meant by not very simple? I can understand why some traders wouldn’t deal with this type of strategy. It requires much more thought and supervision than other strategies.

After closing out the above strategy, you’re left with a net debit of $52,250 for control of 450 shares of Google. Remember that controlling 450 shares of Google outright would cost about $300,000 at $673.

So how the heck does all of that above continuously bring in money and why even bother? I’m not entirely sure myself. Guess we’ll see what happens in the last installment!

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Over on TheStreet.com, Jim Cramer and his partner James Altucher have created a couple of video segments regarding options and a strategy Cramer calls stock replacement. I’ve searched the internet for what stock replacement is and how the theory is applied but sadly came up with the following:

Stock replacement in the spotlight

Investopedia: Stock replacement strategy

Here’s the excerpt from Investopedia:

An investment strategy that attempts to mimic the returns of a certain asset or group of assets by using a combination of different derivatives rather than buying the individual shares in the market. Traders will attempt to profit from the leverage found in options and futures because they can provide the same type of exposure to the underlying asset for a lower cost than if the trader were to buy the underlying assets outright.

An example of a stock replacement strategy would be to buy deep in-the-money options. The reason many traders use this strategy is because the delta of deep in-the-money options is close to 1, which means that the option will increase by $1 for every favorable $1 move in the underlying security. Buying in-the-money options allows a trader to have the same type of exposure to a stock for a lower cost than having to buy the shares. However, keep in mind that incorporating leverage creates a new set of risks, so it is a good idea to contact your financial advisor before incorporating a stock replacement strategy into your investment portfolio.

I was disappointed with the lack of information on stock replacement and for good reason. It’s not as simple as it sounds.

Simple stock replacement is how Investopedia describes it. You purchase deep in the money calls since those contracts are not as mispriced as calls closer to the money or out of the money since the delta is 1. Deep in the money calls roughly move in sync with the stock price. As the stock price rises, the call premium rises by about the same amount. As it falls, the call premium begins to fall by about the same amount until its closer in the money. There’s a great resource on the basics of options and the Greeks over on CBOE.com (Chicago Board Options Exchange) and on 888Options.com.

Now, the stock replacement strategy Cramer describes is somewhat different. The first leg of the strategy is the same as its simple sister. Here’s the first derivation to the simple strategy. The deep in the money calls must be purchased a) about 3-4 months out and b) should be purchased for momentum stocks. Let’s take Google as an example since I think most investors would agree it’s a high flying stock (and for good reason).

At the time of this entry, Google’s share price is at 673. The first step of the complex stock replacement strategy is to purchase deep in the money calls about 3 to 4 months out. On the options chain, we have Google showing contracts open in January and March of 2008. Let’s go ahead and use March 2008 for our example. Strikes for contracts in March 2008 are in $10 increments. Remember that the deeper in the money you go, the less mispriced the contracts are due to the delta. Let’s pick the $610 strike at a premium of $95.40 per contract.

10 x GOOG Mar 610 Call @ 95.4 = $95,400

I know the cost seems high but remember that we’re dealing with Google. This strategy should be able to be applied to lower priced momentum stocks (VMware, Baidu, lululemon, etc..).

Hopefully everything so far has made sense. We’ve made a deep in the money call purchase as the first step in the stock replacement strategy that Cramer and few others use due to its complexity. The next part will show the second and third phases to the strategy as I understand them and how those two phases can command a constant money making cycle.

When ever you start a business either it is a home based business or you are doing / making stock replacing strategy, what ever you do there is always investment risk in your business. For any mishap or any accident it is better to have good and cheap insurance of your business. If you don’t have money then you can apply for loan. There are lots of banks which are offering loans both online and off line such as home loan bank. These banks issue many types of cards and one can get debt with the help of their credit card both online and offline.