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!