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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.

Thanks

Josh

***

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.

Rallies

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.

Declines

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.

Thanks

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