Option Strategies when you lack Conviction

Will markets ever get beyond political headlines and other self-inflicted emergencies? Without conviction, we will continue to see directionless markets propelled by emotions.

So far we have escaped mass hysteria, which explains why there have been no sustained spikes in volatility. Clearly traders’ lack of conviction has more to do with complacency than fear, which means that options are relatively inexpensive. Low cost options open the door to limited risk directional trades like stock replacement strategies.

Stock replacement is not a leveraged strategy which is typically associated with buying calls. Instead, it is a strategy that can be used when you lack conviction and want to mitigate risk. The idea is to buy calls rather than the underlying stock and use the remainder of the money to purchase a fixed income security. The long call plus fixed income will act like a convertible debenture, with the call providing equity exposure and the bond being the defensive component.

To put some meat on this skeleton, let’s examine a stock replacement using Bank of Montreal (Symbol: BMO, Friday’s close: $69.83). While BMO has turned in some decent numbers through the first ten months of 2011 – +14.1% YTD (ex-dividends) – future growth will hinge on how well the economy recovers, and whether the bank is motivated to lend.

Like all banks, BMO is contending with enormous regulatory oversight and have been reluctant to lend to anyone without a pristine credit rating and ample collateral. Consequently, Canadian banks are sitting on a pile of reserves that could be put to work as the economy strengthens. More if US politicians can get beyond the impasse that has gripped Washington for the past two years.

There are two ways to look at this. The bullish scenario posits that Feds tapering will bump up rates, expand net interest margins and reduce loan loss reserves leading to a surge in profitability.

The bears would argue that banks will not engage in higher risk loans until they have 1) a buy-in from regulators and 2) comfort that a riskier loan will not find its way onto its’ loan loss reserves.

Both scenarios are plausible and are, to some extent, dependent on political appeasement. What better reason to engage in risk reduction strategies.

With a stock replacement strategy example, the goal is to use calls as an alternative to buying BMO outright. Suppose you were interested in buying 500 shares of BMO at $69.83 for a total commitment of $34,915. Instead consider buying 5 BMO January (2015) 70 call at $4.00 or better per share. The calls will cost $2,000 and you would then use the remainder of the capital (i.e. the difference between the cost of 500 shares and the cost of 5 calls) to purchase a fixed income security that would mature in January 2015.