CHAPTER lll - LONG STOCK PART 3 [Call Replacement VS Protective Put]

CALL REPLACEMENT

Assume you buy 100 shares of EBAY for $100 per share, and the price increases to $110.

You feel elated since you have executed a successful transaction with a handsome return. You anticipate that EBAY will continue to rise, but you are beginning to have second thoughts. Should you sell the shares at this time and pocket the profit? What if eBay's growth rate persists? Ultimately, you purchased the stock because you anticipated EBay to rise. Despite implementing an exit plan, you begin to question if $110 is the maximum price. What if you hang on and the stock falls back to $100, causing your profit to vanish? What if, after selling EBAY, the stock moves to new highs and you realize how much money you might have made? The psychological aspects of trading might drive you insane. The good news is that replacement therapy may give the proper treatment to address all of these concerns.

Call replacement treatment is just selling the stock to take your profit immediately and replacing the stock position with an identical call position, utilizing part of the profit to pay for the call. Selling the stock permits you to collect your profit, so that if the stock price falls, you have already taken your money off the table. By buying the call, you may still profit from the stock if it continues to grow. As a result, call replacement treatment ensures a minimal profit while still allowing you to benefit from the stock's upward trend. This alleviates all of your concerns since you have money in your hands even if the stock falls, and you gain more money if the stock increases. This is an excellent treatment for investing anxiety.

STOCK MOVES HIGHER

Assume a three-month EBAY $110 Call is selling at $4.00, referring back to the stock you acquired at $100 and which has now risen to $110.

Due to market uncertainty, you are unclear as to whether EBAY can continue to rise or will reverse course and decline, resulting in the loss of your winnings. Under call replacement, you sell the EBAY shares for a profit of $10.00. The profit may then be used to buy the $110 Call for $4.00. The remaining $6.00 of profit is in your possession, and if EBAY's price declines, you've already made a profit. If EBAY continues to grow, the value of the $110 Call option will increase, resulting in more earnings. If EBAY falls lower or sideways and the $110 Call expires worthless, you have already secured a $6.00 profit, therefore your whole position remains profitable. Therefore, after substituting the stock with the call, you may detach yourself from the deal and allow it to play out (Figure 3.10).

The profits from the selling of EBAY shares, less the premium paid for the call, may now be utilized for other investments. You may maintain a bullish position in EBAY while allocating capital elsewhere. Even if you cannot locate another acceptable investment, you may deposit the funds in a money market account or use them to acquire treasuries for the duration of the replacement call, allowing your cash to accrue interest and generate additional income. Combining the proceeds from the sale of EBAY invested in interest-earning securities with the long call creates a synthetic dividend-paying EBAY stock position. The "dividend" is the interest gained on the sales proceeds, and the replacement call lets you participate in the stock's upward movement.

When using a replacement call, it is best to choose an at-the-money or slightly out-of-the-money strike price. In-the-money calls are more costly, and the expense of replacing the stock with calls will consume a larger portion of the realized profit.

Out of the money calls are less expensive, but the underlying stock must move farther for the call to become lucrative and contribute to the total realized profit. If you anticipate that the stock will go much higher, then out of the money calls might be lucrative. Therefore, at the money calls provide the optimal trade-off between cost and profit potential. If a stock is trading between strikes when the decision to replace it with calls is made, it is preferable to choose the next higher out of the money strike rather than the in the money calls.

STOCK MOVES LOWER

If the price of EBAY declines after the first purchase, you may still utilize the call replacement technique to lock in a maximum loss while still allowing the stock time to recover. Remember that under the protective put, when EBAY fell from $100 to $94, you bought a protective put at strike $95 to lock in a minimum loss should EBAY continue to decline. The put still enabled you to earn if EBAY reversed direction and rose higher, since the value of the put increased your breakeven point. Because protective put and call replacement have the same risk/reward profile (long stock + put = long call; see Chapter 2 in Arete Blog), you may attain the same outcomes with a call replacement as opposed to a protective put.

If EBAY falls from $100 to $94, you may sell the shares for $94 and purchase a $95 call option with a two-month expiration for $3. At this point, your maximum loss is fixed at $9.0 ($6.0 in stock loss + $3.0 in call premium).

If EBAY continues to decline, you cannot lose more than $9. Obviously, once you sell the stock for $94, your $6.00 loss is locked in for the loss on the stock. If the price climbs higher, the protective put minimizes the loss on the stock until it gets back over the breakeven point, at which time it becomes profitable. Using call replacement, you take the loss on the stock and hope to recoup it with the call if the stock reverses direction and moves higher.

The benefit of the replacement call over the protective put in this case (i.e., when the stock has fallen) is that your maximum loss may be reduced slightly by investing the leftover profits from the sale of EBAY in T-bills or money market assets. The interest income generated on this investment may mitigate a portion of the loss, and your principal is more or less safely protected. You may seek higher returns by reinvesting the sale proceeds in bonds or fixed-income mutual funds, but doing so would expose you to risk. This is one advantage

of using the replacement call over the protective put—the reuse of the

capital originally invested in the stock while still having the potential for

profits should the stock move back higher.

CALL REPLACEMENT VS PROTECTIVE PUT Call replacement treatment approach elements after a stock has moved higher include locking in a minimal profit while continuing participating in the stock's upward trajectory. The same criteria apply to the protective put adjustment described above. If the risk/reward qualities are same, when would you prefer the protective put over the call replacement or vice versa, given that both strategies are good methods for adjusting stock holdings if the risk/reward attributes are identical?

The primary distinction between the two methods is that one includes stock ownership while the other relies on call options. Therefore, the optimal approach depends on whether holding the stock or the calls is more advantageous for the investor. Stock ownership gives rights and advantages, such as dividends and voting rights, that are not available to option holders. Also, the issue of long-term and short-term capital gain/loss taxes may influence the choice of adjustment strategy, as the call replacement strategy requires selling the stock and incurring a capital gain/loss, which is a taxable event (assuming the investor is not trading in a tax-free account, such as an IRA).

If the stock price has declined, the same risk management concerns apply when deciding whether to purchase a protective put or a replacement call. Both hedge the position by locking in a maximum loss, allowing you to wait to see whether the stock reverses without jeopardizing the whole investment. Therefore, the option boils down to whether you choose to continue holding the stock for the advantages of stock ownership, or if you wish to invest the cash related to the stock in other assets.