Stock Replacement Strategy, An Introduction

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 very little.

Here’s the excerpt from Investopedia regarding stock replacement:

"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.