Is Now The Time For A Stock Replacement Strategy?

The moves in the markets since the March lows, along with the recent winning streaks for the indexes (see Clusterstock article) and various stocks (see Bespoke Investment Group articles here and here), are causing some investors to begin thinking about cashing out and taking some profits. Yet as many investors know, buying is often the easy part, while knowing when to sell can at times be more difficult without some defined metrics and discipline. When things are going good, no one seems to want to jump off the momentum train, even if there could be derailment due to worries about top line revenue growth and earnings that may not be a good as advertised (see articles here, here and here).

So what should you do if you want to stay on the momentum train? One potential strategy is to consider a stock replacement strategy (see WSJ article), allowing you to lock into current profits while still maintaining some future upside in the stock. Replacement strategies are actually fairly simple, at least if you have some familiarity with options. To enter the strategy, you simply sell the stock of the company that has run-up, thereby locking in the gains. You then buy a call option on the stock, thereby giving you the potential to benefit from future upside moves in the stock.

As with any option purchase, you will need to define a strike price and expiration date. Fortunately, implied volatility has come down in in recent months, making the strategy a little more bearable, yet you will need to determine the cost effectiveness of the strategy at current premium levels. As a starting point, Scott Becker, derivatives strategist at Jefferies, suggest options that are at-the-money, with about three months until expiration (see WSJ article). ATM options will allow you to get in the strategy near your stock selling price, while the three months will take you to the beginning of the next earnings cycle, providing a little more information on the market and its reaction to current fiscal and monetary decisions - not to mention give you a little more insight was to whether the consumer finally steps up to the plate, allowing top line revenue numbers to start coming in higher. Others suggest deep-in-the-money options, causing the delta of the option to be near one, providing an exposure and movement that is closer to owning the stock (see Investopedia description).

As always, remember that while the strategy does allow you to offset some risk, and essentially stay in the position, entering any strategy will cause you to incur extra transaction costs and the bid-ask spread, with this strategy also generating a capital gains tax on your initial stock earnings (see Abnormal Returns article). Nonetheless, while no strategy is perfect, stock replacement may be worth considering as the market and your individual securities keep advancing, and corresponding implied volatility decrease.