The Stock Replacement Strategy

In a nutshell, a stock replacement strategy believes in the replacement of stock with derivatives, such that the profits remain the same in cash terms. However, as with all things derivatives, a stock replacement strategy is not a simple trade and requires a high degree of technical analysis. The underlying assumption in the stock replacement strategy is to minimize losses while maintaining the profits. This is done in a fairly straight forward way.

Understand Money Options

The delta of these options is close to 1, meaning that the option will increase by $1 for every $1 increase in the price of the underlying asset. The reverse is also true, that is, the option will decrease by $1 for every $1 decrease in the price of the underlying asset. However, as the option costs less than the underlying asset, the risk is minimized. Experienced traders use the remaining cash for strategic hedging as time progresses. This second part of the stock replacement strategy is not for everyone, as it calls for advanced analysis of the stock movement.

Stock Replacement Strategy

The simple stock replacement strategy itself gives an investor three major advantages and benefits over buying the underlying asset. They are retention of the full benefit of the stock appreciation, and greater return on an investment. The third benefit accrues because the option cost less than the underlying asset.

The more complex part of the stock replacement strategy comes into play only now. Experienced traders now use the cash freed up by buying the options and not the underlying assets to further hedge their bets. They use the difference in the price between the underlying asset and the cost of the option to write out of the money call options against the existing calls in the stock replacement strategy.

This is done to provide protection against the stock moving sideways or slightly downwards. This limits the maximum upside potential of the trade. This stage of hedging is best done when the stock approaches a resistance level. Calculating the timing and resistance level is where the skill lies. The point of this exercise is to reduce the volatility of the stock. This not only reduces the losses but also the profits.

Stock Shorting

Yet another method of hedging your risks in the stock replacement strategy is stock shorting. Here, the attempt is to moderate the losses, if the stock is expected to take a huge correction. This completely protects the stock replacement strategy. Shorting the stocks allows the stock replacement strategy protection from the profits made so far and ensures that you continue to profit should the underlying stock take a prolonged plunge.

There are certain disadvantages to the stock replacement strategy as well. One is that you need a lot of analytical skills to identify potential levels of resistance. If they are incorrectly identified and this can lead to significant losses.

Though a simple stock replacement strategy can be followed by most traders, only experienced players can attempt and come out profitably from a complex stock replacement strategy.

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