This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.
Investors know that if the ETF they own has rallied, they can sell it and book a profit. But selling also means it’s impossible to participate if the rally continues.
Savvy investors know they can buy protective put options on their ETF. While they might lose the difference between where their ETF is trading now and the strike price of their option, that strike price is an absolute floor, although they also have to pay for their put option.
The savviest investors know they can sell their ETF shares now and use a tiny portion of the proceeds to buy call options as a replacement. These call options will allow the investor to participate in any additional upside, while making certain they get what the ETF is trading for currently, although they also have to pay for their call option.
‘Stock Replacement’ Strategy
One institutional trader used this “stock replacement” strategy in the SPDR S&P 500 ETF (SPY | A-98) on Tuesday by selling 125,000 shares of SPY at $209.40 and buying 1,250 of the SPY $210 strike call options expiring on Sept. 18. He paid $2.85 per share for the options.
Our trader is worried about a sell-off in SPY, and wanted to lock in gains or stem any loss—hence selling the shares. But he also knows the market can rally even when it looks troubled, and he doesn’t want to miss a profit. Selling the shares prevents any loss, while buying the call options replaces the upside potential from the shares at the cost of the $2.85 in premium spent.
SPY hasn’t sold off, and looking at the chart below, it’s tough to see any particular reason for nervousness, but traders have learned to worry when everyone else says there’s no reason to.
No Free Lunch
Stock replacement isn’t without cost: Not only does our investor have to pay for the call options he buys, but there’s also a small gap between the $209.40 he received for selling his shares and the $210.00 he can pay to buy them back if SPY rallies.
But that $0.60 is just a fraction of the $2.85 paid for the calls, and the worst he can do is to have SPY drop and see the calls expire worthless. Compare that with the worst he could do if he’d done nothing and was still long 125,000 shares of SPY.
The stock replacement strategy limits the risk to the amount paid for the call options ($2.85 in this case), but the cost of limiting the risk is that the stock replacement will trail SPY by $3.45 if SPY is above the strike price of the call ($210) at expiration.
That $3.45 is a combination of the $2.85 paid in premium and the distance from where SPY was trading, ($209.40) and the strike price ($210.00).
This potential underperformance is the real cost of a stock replacement trade.
Doing a little option math tells us that the likelihood of SPY being above $210.00 at option expiration was about 45 percent. Meanwhile, the odds of being below the $206.55 level where stock replacement begins to outperform was less than 40 percent; the stock replacement is likely to trail, but the difference in potential downside between the two is dramatic.
Stock replacement is a straightforward strategy that offers a unique risk/reward profile compared with simple ownership of the underlying ETF. But surprisingly, like some other basic option strategies, it’s not used as often as it should be.
Making money is difficult enough. Shouldn’t you use all the tools you have?
At the time of this writing, the author owned SPY and had delta-neutral option position in the S&P. Follow Scott on Twitter @ScottNations.