Updated: Dec 30, 2020
Today I'm going to go through a full example of how to perform stock replacement using options. For those of you who already know how, you'll know it's an easy trade that only takes a minute or so, so go ahead and execute the daily trade signal at your leisure. The instructions are down below as usual. For those new to this type of trade, here's the long version :)
Most of the time for pure simplicity, people will just hold the underlying and that's fine. It's easier to do and much more familiar to investors so it is the norm. But there are times when it may be more beneficial to replace the underlying and hold options instead.
1) Options require less capital for the same exposure.
2) Options may allow exposure to certain stocks and ETPs that would otherwise be restricted. Europeans affected by MiFID for example, or perhaps people trading within certain tax sheltered account structures. Long only options may in some cases bypass these restrictions.
3) Options allow for a wider variety of risk management / hedging tools.
4) Options allow a higher focus on things like time, volatility, and leverage, rather than just price like with stocks.
So depending on a persons situation and goals, there are times when stock replacement can be a valuable tool to understand. I've done a few videos on this subject if you prefer videos to articles. You can check them out here:
So feel free to get your paper trading account ready and follow along with today's trade. There's two steps to it:
Step 1) Allocating the right amount of capital. As I mentioned above, stock replacement using options does require less capital to control the same number of shares of the underlying, so one has to be very careful not to over-allocate to the trade. Let me give you an example:
- VXXB is currently trading at about 30$
- 1 option contract is equivalent to 100 shares of the underlying
- 100 shares of VXXB would require about 3,000$ of capital
- 1 "at the money" VXXB Put currently trades at about 4.00$
- That means it only costs about 400$ to control the 100 shares
So at the money, it's technically possible to control about 8 times the number of shares of VXXB with the same capital outlay. This would of course be a highly leveraged position. I'm a conservative investor and almost never use leverage. In fact my Total Portfolio Solution focuses heavily on risk management and almost never even uses the full amount of available capital, let alone any leverage. I believe the best way to improve long-term performance is to reduce risk and drawdowns, so leverage is a no go.
The simple rule that I have within the VTS Tactical Volatility Strategy is that I always allocate the same amount of capital that would be required to hold the underlying shares.
This means no matter what the option actually costs, I would only purchase 1 option contract per 3,000$ in desired capital outlay, despite the fact that I could technically buy many more than that. In this example for a stock trading around 30$, I'll still only purchase 1 option contract per 3,000$ scale.
Step 2) Choosing the right option contract. There's three factors to consider here:
1) We need higher liquidity, so I only choose strike prices with a higher open interest. I typically don't have any trouble getting fill prices around the mid point, but it's better to focus on strike prices that have higher open interest.
2) I always choose longer dated contracts. Long options are what's called Theta negative, which means they decay with the passage of time. To reduce this decay factor, I select options with longer dated contracts several months from now, and I rebalance regularly to keep the Theta minimized.
3) I target options with roughly 0.7 Delta when possible. Delta is the option greek that shows sensitivity to price movements in the underlying instrument, so a 0.7 Delta option will move roughly 70% speed, in both directions. This reduces the leverage factor even more.
* I have a rather "geeky" article here on the Option Greeks if interested
* The old XIV was a 1x leverage product, and the current SVXY is a 0.5x leverage product. So a 0.7 Delta VXXB put option is roughly in between the old XIV and the current SVXY as far as leverage.
VXXB option string for the June cycle, 116 days to expiry
Market conditions currently show a headwind for a long volatility product like VXXB, so I will be buying a long Put option. Puts are on the right side of that screenshot. So which one do you think is best?
If I'm looking for both a 0.7 delta and a high open interest, the best choice is the 40$ put right? Exactly 0.7 delta and it's the most active strike with over 14,000 contracts open already.
BUY to OPEN 21 Jun 19' VXXB 40 Put Current debit: ~ 11.70 prices move around intraday so this may change, target the mid
* Buy 1 option contract per 3,000$ in desired capital allocation
If the current debit is about 11.70, that only requires 1170$ per 1 contract. However, remember the rule. I buy the number of options that correspond to the desired allocation.
VXXB is currently trading around 30$, or 3000$ to hold 100 shares. That's the "effective" trade value.
Example) If a person had 10,000$ to allocate to this trade:
10,000 / 3,000 = 3.33 Round down to the nearest whole number of 3 Buy 3 option contracts
Example) If a person had 25,000$ to allocate to this trade:
25,000 / 3,000 = 8.33 Round down to the nearest whole number of 8 Buy 8 option contracts
I don't personally use stop-losses for volatility ETP trading. I allow my volatility metrics to move me in and out of trades. Obviously you are free to use them if you choose, and if it gives you peace of mind, do it. If you want to know more about why I don't use stop-losses, I have a whole video here:
Because this trade is Theta negative, it will require rebalancing if the trade remains open for too long. I would estimate that if the trade is open for longer than about 3 weeks, I will close it and move it out to the July expiration.
So that's a basic example of stock replacement using options. I realize that's a very long explanation and may sound complicated, but believe me, once you get the hang of it these trades are as easy to execute as any other stock position. It only takes me a few seconds to execute these.
So feel free to open a paper trading account and follow along. That way you can learn the mechanics and see a few of them risk free before allocating any real capital. When you're ready, you can move to small trades with real money.