Blog Spotlight: Abnormal Returns

Another edition of our new series:  Blog Spotlight.

We put together a short list of excellent but somewhat overlooked
blog that deserves a greater audience. Expect to see a post from a
different featured blogger here every Tuesday and Thursday evening,
around 7pm.

Up next in our Blogger SpotlightAbnormal Returns. AR is a year old blog written by a private investor with
nearly two decades of experience in the markets.  His experience
includes a stint in a variety of roles with a mainstream investment
management organization, extensive publications in the practitioner
literature, and a hedge fund start-up.  The Abnormal Returns blog is
focused on investor education and unearthing items of interest for the
investment blogosphere.




Today’s focus commentary looks at Stock Replacement Strategies in the Spotlight


Replacement Strategies in the Spotlight

Seldom a day goes by
without the financial press reporting on some new financial product innovation. 
We have been attuned to the fact that with this increase in choice also comes a
need for education and proper context. 
ETFs are clearly the most visible
innovation, the list does
not end there.  Option volumes have
showing an increasing
interest on the part of investors to more closely match their viewpoint with the
most appropriate financial instrument.

here at
do not claim to be
options experts, but the time is right to explore an interesting options-related
opportunity.  The stock market, measured by the S&P 500, has run up from a
June low of some 1220 to a recent high of nearly 1390, for a gain of some 14%. 
With some
measures becoming a bit overextended it should not come as surprise that some
investors are looking to reduce their overall market exposure.

just so happens the stock market is providing us with just such an opportunity. 
During this stock market rally implied volatilities have fallen back to the
lowest levels of the year.  For example the VIX is hovering right around 11% at
the time of this post.   This
allows for what are best
described as ‘stock replacement’ strategies.  This involves selling appreciated
stock and replacing it with an equivalent call position.  The long call position
would be calibrated such that it provides roughly the same exposure as the
original stock position.

This serves two purposes. 
First you can maintain the original long stock exposure, with the assumption
being that it remains an attractive one.  However you have locked in the gain on
the stock.  Second, holding calls reduces the downside risk from continuing to
hold the original stock position.  If the stock declines, the call position can
obviously not drop farther than the premium paid.

currently low volatilities allow investors to do this for a relatively low
cost.  If implied volatilities were high, this strategy becomes cost
prohibitive.  In short, you would be paying much more for the implied downside
protection.  While we are discussing individual stocks, the same strategy could
be used for index-like positions as well. With the increasing number of ETFs
that have listed options the opportunity to use options strategies is

not sell out the stock altogether?  A couple of reasons. The first being
presumably you own the stock for some sound fundamental reason.  Even in an
overpriced market there presumably are attractively priced stocks.  Second,
unless you are a hard-core market timer, eliminating stock positions in their
entirety is a large bet that the market will drop dramatically.  A stock
replacement strategy has the advantage of being a middle ground.  You continue
to have long stock exposure, but the risk of a dramatic drop is offset by the
nature of the underlying calls.

an aside, if this talk of options, specifically implied volatility and calls is
confusing to you then you should stop right here.  You should feel comfortable
with the mechanics of options pricing and trading before considering any sort of
options-related strategy.  While options pricing isn’t rocket science it does
require a thorough understanding before proceeding.

strategy, including a stock replacement strategy is perfect.  First off it
requires additional trading including commissions and bid-ask spread.  Second,
if you hold the original position in a taxable account, presumably the stock
sale would incur capital gains taxes.  Third, this strategy is not a risk
enhancing strategy.  Properly used it should help mitigate risk, not be used to
ladle on additional market exposure.  Fourth and maybe most importantly, there
is the risk that the calls simply lose value over time if a stock and/or the
market remains range bound.

no means should this post serve as your sole source of information on stock
replacement strategies. 
at the Daily
Options Report
has covered the topic of
low implied volatilities and stock replacement strategies on more that one
serves as a good primer
on stock replacement and begs the question why more market pundits don’t comment
on the strategy. 
takes a different approach, but comes to much the same conclusion.  Dorsey
focuses on the use of longer term options (LEAPs) as a piece of a stock
replacement strategy.  In the article he also includes data on some of
Morningstar’s most attractive large cap stocks with low implied

stated earlier, we make no claim to any great options expertise, but a stock
replacement strategy is pretty intuitive.  Competition and innovation have
helped created a marketplace in financial instruments that make strategies like
this feasible and not cost prohibitive.  With this greater investment
flexibility comes a need for a commensurate amount of investor responsibility. 
As a self-directed investor you should feel comfortable both with the investment
case for the underlying stock or ETF, and the pricing and mechanics of any
options used before implementing any strategy, let alone a stock replacement

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What's been said:

Discussions found on the web:
  1. Sammy20 commented on Nov 2

    Hey Barry,

    You haven’t been on Kudlow in a while. Has he put you on the banned list (i.e. anyone who does not think this is the greatest economy ever) in order to continue the vote republican because everything is great hype?

  2. whipsaw commented on Nov 2

    good choice for the blog spotlight, BR, but I don’t quite follow the proposed stock replacement strategy. It seems to me that they are overlooking the utility of using puts to lock in gains, e.g.:

    You could have bought 100 shares of INTC in June for $17~ and it closed today at $20.58. If you sold and bought a 20Jan08 call, it would cost $3 and you have essentially spent your profits on the call. If and when the underlying gains $3~ and/or volatility picks up enough to push the option price up anyway, you break even, but you will also be hearing the clock tick the whole time.

    Another alternative would be to buy the 10Jan08 call for $10.80, in which case you are only paying a time premium of $.22 but have also tied up your profit as well as 59% of your original investment in the ongoing investment. That would act more like a future than an option which is okay, but…

    Why not just buy a 20Jan07 put for $.65 while keeping the underlying? That would protect most of the profits. If it expires worthless, buy another one then if you like (a 20Jan08 put is currently $1.70 and if you are bullish, by definition you would not buy a LEAP put). This would also provide an opportunity to achieve long term gains, while the call approach might not in my example. The only downside is that you are putting more cash into the position, but we are talking about $65 to protect a $350 gain, so….

    My other comment is that any retail account has to be options qualified and some brokers are pretty fussy about this since they don’t want to listen to the whining when Joe Chump’s GOOG 500Jan07 calls expire worthless. Options are interesting and useful, but understanding them requires a lot of honest study that many people don’t care to undertake. That said, my own approach is 10-15% options of one kind or another and the balance in bonds and CDs or cash.

    Sort of off-topic, I was thinking about buying some VIX calls given how low volatility is and seem to recall some chatter about how there were many who were disappointed with trading the VIX for some reason. Can anyone provide a little insight into this?

  3. Barry Ritholtz commented on Nov 2

    Because of the tendency for the VIX to kinda snap back, options buyers have to get the price, direction and timing pretty dead on.

    As to Kudlow, ts been all politics all the time — after the election, (and when I return from Sebring), I should be back

  4. wcw commented on Nov 2

    ws, buying puts while holding stock creates synthetic calls. put-call parity ensures that whatever strategy you like will be available either as a synthetic or directly, usually at more-or-less the same cost. if anything, as a rule puts carry a touch of a vol premium, though usually not too steep, or it’ll be arbed away by traders.

    the one advantage for the synthetic is in taxable accounts if you anticipate sideways-or-up markets. then you avoid taxable events, but slowly bleed premium you can write off, versus a stock-replacement that generates an immediate gain and potentially more to come. in a down market, you would have wanted the replacement, since your stock gain was probably long-term, but put profits will probably be short.

    VIX options are not what they seem. cf “VIX option prices should reflect the forward value of VIX, which is typically not as volatile as spot VIX. For instance, if spot VIX experienced a big up move, call option prices might not increase as much as one would expect. Depending on the value of forward VIX, call prices might not rise at all, or could even fall! As time passes, the options used to calculate spot VIX gradually converge with the options used to estimate forward VIX. Finally, at VIX options expiration, the SPX options used to calculate VIX are the same as the SPX options used to calculate the exercise settlement value for VIX options.” I bought and actually made money on them this calendar year, but since then have stuck with buying lots of volatility in different places when I wanted to be long vol. right now I have a ton, not all below 9% like the SPX’s, but pretty much all at or near the bottom of historic ranges. if markets go all funny, I’ll profit without worrying about the oddness of VIX. I have been tempted to buy VIX futures directly, but haven’t bitten yet.

  5. whipsaw commented on Nov 3

    per BR:
    “Because of the tendency for the VIX to kinda snap back, options buyers have to get the price, direction and timing pretty dead on.”

    ah, ok Barry, then I will cross VIX off of my list since I am generally not good at guessing all of those things at once (with the exception of SPY in May). They make straddles and strangles for people like me tho. :p

  6. whipsaw commented on Nov 3

    per wcw:
    ws, buying puts while holding stock creates synthetic calls.

    yup, I already understood the synthetic call stuff. But I wasn’t aware that options could be used in a non-taxable account at all, so I am not sure if I follow some of what you are saying. My basic point was that you could collar the gain with a put for less money and maybe less risk than you could with a sellout followed by a call- do you agree with that?

    VIX options are not what they seem

    ok, that’s the kind of stuff that I recalled seeing here before and I think I’ll just pass on the VIX and wait for the charts to tell me to short QQQQ or IWM.

    I really appreciate your comments tho, very useful.

  7. A Dash of Insight commented on Nov 3

    Blog Spotlight: Abnormal Returns

    We are delighted to see Abnormal Returns, one of our favorite daily reads, in the spotlight. The strategy suggested is excellent, particularly right now. Take a look at Barry Ritholtz’s post and then come back for our comment. Link: Blog

  8. Jaymay commented on Nov 4

    What are the tax implications of this strategy? Or does it all come out in the wash?

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