What is Stock Replacement Strategy? Stock Replacement Explained

Friday, October 16, 2009

What is Stock Replacement Strategy?

Stock replacement strategy, as the name suggests, is a strategy to mimic the returns of trading stocks through derivatives. The strategy aims at profiting from a stock, without directly trading the stock. In stock replacement strategy, traders use options (especially deep in-the-money options) and futures on the stock. For example, traders can buy deep in-the-money options having delta close to 1, then a $1 rise in stock price will also cause a $1 rise for the option.

Advantages of stock replacement strategy:

The strategy offers all benefits associated with trading (group of) stocks.
Reduces costs associated with opening long positions and holding them.
Offers more leverage, most money can be retained for hedging purposes.
Offers low downside risk, with options traders having the option to do or not to do, and futures positions can easily be offset.
Both simple and complex options trading strategies can be followed for getting custom results.

Disadvantages of stock replacement strategy:

Needs good trading experience and skills to master the strategy.
The strategy may fail, when the stock stays on (almost) the same price or moves sidewise with minimal volatility.
Sometimes the costs of trading options can match or exceed those of trading stocks.