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When to combine stock with options

Chris McKhann (chris.mckhann@optionmonster.com)

Many advanced option veterans avoid trading stock, but there are times when it makes sense to use both in certain strategies.

Covered calls are usually the first option trade that people learn, selling calls against long stock to generate income and lower the cost basis of the shares. From there, traders often move onto buying puts as protective hedges and/or to using collars , which simply combines the two strategies.

After getting this initial taste, many traders decide that they'd rather use options alone. For example, they find that selling cash-secured puts theoretically carries the same risk as a covered call but has advantages over the latter strategy.

Moreover, buying puts against long stock can be replicated by buying calls , which has a much lower margin requirement. And collars are essentially identical to long-call vertical spreads , which tie up much less capital.

But there are times when combining options with stock makes the most sense, especially for long-volatility plays . Some traders believe that it is much easier to see if volatility is too high or low than to pick the direction of the underlying stock. If traders think that volatility is too low but aren't sure about the stock's direction, they could opt for positions that are long volatility.  

Others are introduced to the long-volatility concept through the long straddle . The straddle is simply the purchase of long calls and puts at the same expiration and strike. So if XYZ shares are trading at $50, you would buy the $50 calls and $50 puts. If XYZ moves sharply in either direction, then the position can profit.

The problem with long straddles, however, is that you are paying the premium of two option contracts and have to overcome time decay in both. Many people try straddles going into earnings, which is often the worst time to be long lots of option premium because it gets pumped up going into the unknown news.

Unfortunately, it quite common for us to hear from new option traders who have lost money this way. Others might be long just calls or puts and were right on the stock's direction but still lost money because the so-called volatility premium they paid was too high.   

But you can create a similar position by buying either puts or calls and trading stock against them in what is known as delta-hedging . For instance, a trader might buy at-the-money puts and then delta-hedge them by purchasing the same number of shares.

If an option's delta is -0.50 and 10 contracts are bought, then the overall delta is 500. So 500 shares would need to be purchased to create a long-volatility, delta-hedged position. In this sense, using the options against stock instead of a long straddle can be a better way to "buy" volatility. (See SPY example in graphic below)

Conversely, many traders do the opposite to create short-volatility positions. It can be argued that the short straddle makes more sense because of the double time decay mentioned above, but the stock-and-option position is easier to manage and continuously hedge.

Again, most option traders don't use stock in strategies that can be easily replicated by options alone, but delta-hedging volatility positions is the exception.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Aug. 1. Graphic courtesy of tradeMONSTER .)

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