This column was originally published on RealMoney on March 9 at 9:28 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
In light of the market's recent volatility, it might be a good time to use options in your portfolio. Specifically, consider employing a replacement strategy. That simply means selling the stocks you own and replacing them with call options.
This accomplishes several things. First, it reduces the capital requirement because the cost of the option will be far lower than the price of the underlying shares. This should help free up money to diversify your portfolio further and go shopping on the next pullback.
Of course, the cost savings and risk reduction will be a function of which strike or option you choose to buy. You'll have to decide how far in or out of the money you want to go, which expiration you want and/or how much time you'll buy.
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One of my general rules of thumb is to avoid going any deeper than one strike in the money. Otherwise, you're basically replacing stock with a highly leveraged financing tool in which the value of the option will move on a 1-to-1 basis with the price of the stock. A 5% decline in the stock will result not only in an equal loss in dollars in the option value but also, on a percentage basis, in a possible loss of 25% or more. That is certainly not risk reduction.
Another of my guidelines is to buy an option that has at least four months remaining until expiration. This provides enough time (hopefully) to rise through a rough patch while not suffering too much time decay. Time decay really kicks in and accelerates once you get about three weeks away from expiration, so at that point, I would consider closing the position or rolling it into a longer-dated option.
Most importantly, when choosing the number of contracts to purchase, use the delta-equivalent share count,
the amount of money invested in the underlying shares. For example, if you own 1,000 shares of
Chicago Mercantile Holdings
-- which has been on a real roller-coaster, going from $590 down to $500 and back up to $565 in the past six months -- you would not buy $565,000 worth of call options.
Instead, you might look at September $570 calls, which are now priced at around $45 per contract. These at-the-money options have a delta of 0.5, meaning that for every $1 move in the stock, you can expect a 50-cent move in the option. So to have the equivalent of 1,000 shares, you might buy 20 contracts.
But because delta will increase as the share price rises, I'd suggest only buying about 15 contracts. This would be a $67,500 total cost for the 15 contracts. While that's certainly a big number, it only represents about 15% of the cost of the shares.
Remember, the delta also declines as the stock price falls, so just as gains and position size accelerate on rallies, the losses and exposure diminish as the share price declines. If you look at a lower-priced stock, the numbers become more palatable.
The biggest drawback of the replacement strategy is that the premium you're paying for the options can be a significant hurdle to achieving profitability. In the example above, the $45 option price represents an 8% premium or price hurdle. But that's certainly not insurmountable for a stock that has gained more than 500% in the past three years and is capable of 25% price moves in a matter of months.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;
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