Delta Neutral Stock Replacement

Hi Mark,

If wanted (roughly) the same potential return of a stock with limited
risk, and the ITM option's delta is 80, would raising my position
size by about 25% do that?

To be clear, I'm thinking in terms of options' implied leverage and
their implied stop loss as an alternative to buying stock and entering a
stop loss order. So if I would have bought 1000 shares of stock, I
would be buying 10 options instead, and am wondering if buying 12 or 13
would bring the delta up to 1000, as it effects my account.

Hope that makes sense.




Yes Josh it makes sense. Owning 12 or 13 options with an 80% delta gives you almost the same 1000 long deltas.  Most stock replacement strategies replace 100 shares with a single call.  Your plan provides the obvious benefits on a rally or a big decline, but there is an added benefit (the 'implied stop loss').

So to have
'roughly' the same return (measured in dollars not in
percentages), you can substitute the calls for stock.

I'm sure you recognize that these deltas change as the stock price changes, due to positive gamma.


Every so often, on a rally, the plan should be to sell one call to reduce delta back to 1000.  Obviously, you would have only 10 calls remaining when the delta reached 99 or 100.


But it's not quite the same on the downside.  If you buy calls on a decline – to get back to 1000 delta, you will fare poorly when the stock continues to go lower.  I would not buy extra calls.

Is this a smart idea?

The negative:  you must pay for time decay. 

The positive: That time decay is your cost for reducing downside risk.  Only you know the value of that risk reduction, but it seems to be a good idea to me.

There is one HUGE advantage to using a long call option instead of a stop loss order.  With the stop, you are out on a decline.  With call options, you are still in the game if the stock suddenly reverses direction, after ticking the stop loss price.  And there is no whipsaw and no extra cost.  You bought the calls – and this is one of the benefits of owning calls in place of stock.

This advantage makes it worthwhile to pay that theta decay.  And this is truly much better than the traditional stop loss.  I'd be willing to pay a bit extra in daily decay to own this position.

Good question.


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16 Responses to Delta Neutral Stock Replacement

  1. Josh 04/16/2010 at 12:46 PM #

    Thanks for the reply…
    Any thoughts on a general rule of thumb for how deep ITM and how many months till expiration for trades that last 2 to 8 days (trading days, not calendar days)? This is assuming implied volatility for a stock isn’t high or low relative to it’s recent average.
    Btw, I love the blog. You’re responsible for at least 90% of my options education. Thanks.

  2. Josh 04/16/2010 at 1:01 PM #

    Just to add a little context, I’m an automated trading systems developer, and one of my biggest headaches is adding stop-losses to any given system without drastically reducing returns. So your last point about still being in the game is a major part of the attractiveness of using options. Not to mention when a stock gaps up or down past your stop, leaving you with a loss higher than you prepared for.

  3. Mark Wolfinger 04/16/2010 at 1:52 PM #

    Thanks Josh,
    If you are trading short term, I believe front-month options are right for you. But this is an opinion based on nothing. I don’t trade front-month 20 delta puts (which correspond to your 80 delta calls) enough to help you.
    But, you want some positive gamma, and front month supplies that. For a short-term trade, the time decay will not be costly.
    I assume these plays are for a swing-trade – or a directional play that takes about a week to run its course. If that’s the case, there is noting magical about trading 1000 delta positions. You can trade 10-lots, or any other quantity that feels comfortable – if indeed you are making a directional play.
    There’s not much leeway for ‘points ITM.’ If you choose the delta, there will be only suitable option per expiration month.

  4. Mark Wolfinger 04/16/2010 at 1:54 PM #

    I don’t like using stop loss orders on option trades, but using options in place of stop loss orders for stock trades is an excellent idea.

  5. Josh 04/16/2010 at 2:08 PM #

    “But this is an option based on nothing.”
    Sorry, I’m not following you, what does that mean?
    Thanks again.

  6. Mark Wolfinger 04/16/2010 at 2:25 PM #

    It means I cannot spell. It’s an ‘opinion’ based on nothing.

  7. scott 04/16/2010 at 3:06 PM #

    Not sure where I put a new post (off topic). Just wanted to say I completed my first full Iron Condor trade, and I was a Loser, however, I know why I was a lloser, learned a tremendous amount and the cost of the loss was well within my risk tolerance, so I do not consider it a loser in the overall sense. I also put on the second part of a May Iron Condor today. I decided to get in the call side several days ago and wait for a pull back before enterring the put side. This is an incerible learning process, but this blog is helping me immensely. I am confident I will not repeat the same mistake I made last month. I am sure I will have new mistakes but at least one is out of the way.

  8. JB 04/16/2010 at 3:46 PM #

    Hi Mark,
    I have thought about the idea Josh has brought up. What I’ve wondered is that since I would purchase the calls (itm delta 80 or so) on a down day for the stock and the VIX and IV for the option would be high. I think I would want to be selling, not buying, at a high IV time. So this would imply selling a put spread ( credit spread) which of course limits the upside.
    So, the question in all this is: How does one decide if IV is too high to do the call purchase? I am thinking more of 2 to 3 months till expiration.
    Thinking out loud. Since one would like to sell high IV and buy back cheaper at low IV, this seems to imply using puts. When IV is high, sell puts and buy back at lower IV. When IV is low buy puts and hope to sell at high IV. The results of this “Thinking out loud” is to use puts and not calls, if the logic in the first sentences of this paragraph is accurate.
    Love the blog ( unfortunately I don’t get to read it everyday–(working stiff) and your teaching via the blog.
    I also add a personal recommendation for your books for anyone reading this.
    All the best.

  9. Mark Wolfinger 04/16/2010 at 6:45 PM #

    Off topic is best placed on the most recent post. Just as you did.
    Loss can be considered tuition – especially when you know you learned something useful.
    Appreciate the words of support.
    Here is a big truth for traders: We all make mistakes. If you learn something that truly helps you eliminate that mistake in the future, you will be a successful trader.
    I want to add an opinion: Losing money is not a ‘mistake.’ Earning a profit does not mean you did not make a ‘mistake.’
    You are off to a good start in May. Best of luck with the position.

  10. Mark Wolfinger 04/16/2010 at 7:00 PM #

    I understand your concern. You can get a good handle on just how expensive it would be to buy the calls when the market declines and IV increases. Use (
    Answer these questions and let the calculator tell you how much it would cost. Then decide if it’s too much to pay. You should be able to tell whether it’s truly too expensive to buy calls on a decline. It’s a comfort zone situation.
    And if it’s difficult to know if the amount you calculate is reasonable, then buy half as many calls as you would normally buy, and by managing the position, you will know how much you like what you did and whether to try your ‘normal’ size next time.
    1) Pick the stock. Pick the option you believe you would buy on that dip.
    2) Change the stock price so your option has an 80 delta. Look at the TV (theoretical value).
    3) Raise IV. You will have to guess how much to raise it. Look at new TV. Compare the cost and decide if it’s too much extra to pay to get the benefits of owning calls instead of stock.
    4) Change the date (by one week) a few times and make a table of how much time affects the TV difference.
    5) If you decide it’s too costly, then you may have to settle for selling the put spreads. Less profit potential, so be very careful you don’t sell too many of these.
    Be certain maximum loss from sale of put spreads does not exceed maximum loss from call purchase. The idea behind buying these calls is to limit losses in a market swoon.
    6) Buying put spreads when IV is low is not a good idea. It’s taking a double position: Negative delta and positive vega (volatility). Unless you are an experienced volatility trader with a good track record, you do not want to make this play. Do not misunderstand: Closing spreads you sold earlier is fine. It’s going long that concerns me.
    Glad to have you visit whenever it’s feasible.

  11. JB 04/18/2010 at 7:41 PM #

    Hi Mark,
    Thanks for the thoughtful and useful response. Actually, you always do respond and they are thoughtful and useful– this trifecta, if you will, is not often seen, especially on the web. Thank you for it.
    I’m not sure I understand in your response item #6, in Delta Neutral Stock Replacement thread. If IV is low, there is unjustified complacency in the market, as I understand it, and accordingly the market and the stock are vulnerable to a decline. Buying puts or put spread. (I am meaning the spread is buy higher priced put sell lower priced put) is best done in a low IV environment and has the built-in stop-loss mechanism of limiting the loss–obviously to the amount paid. I thought this was a strong point in Josh’s method. Would a call spread (sell higher priced, buy lower priced) be of less concern?
    What are some good and simple ways to play the “low IV, expect a decline in the underlying asset senario” I am making the assumption that a market decline is almost always accompanied by a rise in IV. Is this a bad assumption – one that is likely to “bite” me?
    I know that for the most part selling spreads has better overall outcome ( outcome = expected value (x) gain/loss) but I am thinking of this methodolgy as an insurance type of play and one pays for the insurance.
    Thanks. And all the best, as always.

  12. Mark Wolfinger 04/18/2010 at 7:52 PM #

    Thanks JB,
    Good points being raised.
    I’m behind on replies. I’ll post on this question Wed 4/21/2010

  13. Jason 04/19/2010 at 10:53 AM #

    Hey Mark,
    I want to to put a portion of a portfolio into a 2yr index option to produce growth based on the whole. I’m sure you’ve heard the strategy. 90% into a safe vehicle like 2 yr Treasury and 10% into a 2 yr index call option.
    My question is how the option correlates with the real index performance. For instance, if the index is up 5% 6 months in does my option increase at an equal dollar amount as if it were on the full account?
    Does this make sense?
    Ex: $120,000 portfolio. $12,000 into a 2 yr S&P call option. Remaining into 2 yr notes. If market rises 5% in 6 months and the whole account had been invested this would be a $6,000 gain. Will this be a $6,000 gain on the index option also or is it different based the time value of the option?

  14. Mark Wolfinger 04/19/2010 at 1:09 PM #

    I’ve never heard of this strategy, or if I did, I paid no attention to it.
    1) For $20,000, you can buy one SPX Dec 2011 1050 call option. That’s less than two years, but it’s the nearest you can get right now.
    Current SPX price is 1188. This option has an intrinsic value (the amount it is ITM) of 138 points and thus, the remaining 62 points is the time premium.
    2) Because you plan to hold this option until it expires – at least that sounds like the plan – your break even point is 200 points above the strike, or 1250.
    3) So the question you need to ask – is not where the option would be priced if we are up 5% in six months. The question is: Is this the way you want to invest in the stock market?
    I am not offering an opinion on this one. It’s 100% your choice.
    4) In Dec 2011, if SPX is where it is now, you lose $6,200 that you paid in time value. A loss of 30% of your investment and 5% of your portfolio.
    If the market is tons lower, you lose only $20,000 – so that’s a good result.
    If the market rises 10% to about 1300, you earn $5,000. That is 25% on your $20k investment. But it’s less than 5% on your $120k portfolio.
    You can easily work out the results for other scenarios.
    5) Look at your last question. You want to know if the value of your option would increase by $6,000, or 30%, when SPX rises by 5% in six months.
    Do you believe that is possible? It is possible, but you would have to own several OTM options and not one ITM call. The obvious problem with that is the very real possibility of losing 100% of that $20k investment. I just make the assumption that you would never consider doing that.
    6) To get an answer to your question, use an option calculator; move the price up 5%; move the date out 6 months and then guess at at implied volatility. I have no idea what that will be.
    I never heard of anyone suggesting this plan. I see the benefits and the risk. I also believe in stock replacement – per our earlier discussion. But this is nothing similar to the plan you suggested earlier.

  15. Jason 04/19/2010 at 2:01 PM #

    Ok … this was in McMillan’s “Options as a Strategic Investment” book as a “Treasury Bill/Option Strategy” and I’ve seen it as the 90/10 rule a few other times as well. Idea is that you risk about 10% on a call to leverage the equity portion minus any interest earned from the safe side. Seems like a pretty good strategy.
    Maybe Im looking at this wrong but I see a Dec 2012 1200 SPX call selling for around $150. A $120,000 account could purchase about 1,000 shares of the spy on at market right now so 10 option contracts to equal this would be around $15,000 or 12.5% of the account. If you invest the remaining $105,000 into a 2 yr Treasury note at 2% annual (I know this is high, just for demonstrative purposes) that would bring the account to around $109,500 over a 2 yr period risking a total of $10,500 or 8.75% total which equates to about 4.3% annual risk assuming not upside market growth.
    Im just trying to figure out apples to apples on the growth rate of the call versus actual shares held. I see your points. How can I calculate “if the market rises by X% over a 12 month period my 2 yr call will increase by what dollar/percentage amount??”?

  16. Mark Wolfinger 04/19/2010 at 2:31 PM #

    Yes it does seem to be a pretty good strategy. And when you suggested using 80=delta calls as a stock replacement, I agreed. Those calls were priced so that you could buy 10 or 12 of them.
    But, you are off by one decimal point. An option priced at $150 costs $15,000. And 10 contracts requires $150k. You cannot do this ‘trick’ with LEAPS options.
    You will find that owning one such option contract does not provide the market participation you need.
    Use an option calculator.
    Change the price from current price to x% higher. Change the date to whatever you want it to be (or 1 year less time remaining prior to expiration). You will have to use a few different volatility estimates. Then look at the theoretical option price. That’s your estimate of what the price will be.
    Is there some reason you cannot do this? I have mentioned it more than once.
    In this example, it’s one year from now.