Options In Focus: Stock Substitution

The trend, so they tell us, is our friend. But when conditions permit, a more reliable ally for bulls (or bears) are options that look to be a stronger fit for positioning than holding shares of a particular holding.

In late trade Tuesday, with the CBOE Volatility Index or "VIX" down about 1% at 23.80%, a better-suited way to ride the market's nascent uptrend or bear market rally, depending on whom one talks with, is likely through a stock substitution strategy.

A stock substitution strategy is a fancy way of saying you've done the hard work of accruing profits, maybe over the past three or four sessions for instance, and are now looking to lock in those returns with an absolute guarantee not subject to any pesky and unwanted price gaps.

When option premiums are affordable, as they currently are by and large, stock substitution for bulls can simply mean selling out shares and putting a percentage of those winnings into a certain amount of long calls.

As the strategy typically employs at or out-of-the money options at initiation, gains will likely trail results if we simply held stock on the initial move. But if shares continue to rally above the purchased strike, we could wind up a bigger winner than we would otherwise.

This profit phenomenon is sometimes possible despite less capital being put to work due to an option's leverage. Leverage, particularly with at and out-of-money options and when premiums are affordable / cheap, can allow for greater contract sizing relative to shares. And on a sizable and favorable move in the underlying, the result is the implemented call or stock substitution position, can dwarf the profits of the stockholder.

Options In Focus: Stock Substitution

To illustrate this principle, we'll use IBD 100 and NASDAQ 100 component Altera Corp (ALTR). Shares broke out from a fairly nice cup-shaped base with handle last Wednesday as the market signaled a somewhat suspect follow-through day. Let's suppose a trader purchased 300 shares and continued to hold the position over the next four sessions.

With shares up two points from the proper breakout point, the trader has net profits of $600 with which to work but is only willing to sacrifice 50% of those gains. Checking the board and one idea which keeps slightly more than $300 of the trader's profits and would eventually outperform holding the long stock position are 4 August 30 calls priced for just under $0.70 per contract.

Truthfully, the upside outperformance of this call position with under 40 days to go, isn't likely to occur. However, profit-taking isn't could always make an appearance. And on that defensive note, a stock substitute compromise on one's own terms is an idea worth consideration.