Stock Replacement And Leverage
Both call and put options offer leverage to their underlying asset and cost a fraction of the underlying security’s price. Despite only paying a portion of the upfront price, the holder of a call (put) option receives the entire upside (downside) above (below) the strike price less the upfront premium paid. Therefore, options offer leverage as they provide the ability to purchase upside (or downside) of a security without paying for the entire cost of the security.
Investors can benefit from the leverage in options through “stock replacement” trades. A stock replacement trade consists of purchasing a call (put) option in place of a long (short) security position. Since the option costs a fraction of the cost of the security, an investor can allocate far less capital to the investment. Investors can then purchase options with higher notionals as a way to get leverage. Additionally, stock replacement strategies can be less risky than outright long/shorts as the position’s maximum loss is limited to the upfront cost of the options.
Example 4: An Investor Underweight Equities Misses A Sharp Equity Rally And Catches Up By Buying Call Options On Equity ETFs
Since the bottom in March 2009, equity markets have had distinct periods of sharp rallies (Figure 12). However, given the risks within equities, many investors have been underweight equities through these rallies. To keep up with benchmarks, investors that missed rallies may need to catch up. One approach is to purchase higher-beta equities with the idea that should the momentum continue, those high-beta names will outperform their equity benchmarks. However, call options on equity ETFs (i.e., SPY, IWM, QQQ) offer another solution to catch up to an equity market rally. With the leverage in options, investors could purchase options on higher notionals, which would outperform should the rally continue.