Reduce risk by buying call options

This also means that options are relatively inexpensive, which opens the door to directional trades with limited risk: buying calls, for example, as a stock-replacement strategy.

Say your client owns shares in the hypothetical XYZ Corp. The client could sell the shares and replace the position with a long XYZ call option. Or, for new positions, the client could buy calls rather than the shares, using a few dollars to buy the calls while putting the remainder of the capital – i.e., the monies that would have been used to buy the shares – into a treasury bill, guaranteed investment certificate or perhaps even bonds issued by the underlying company.

Stock replacement is not a leveraged strategy that’s typically associated with buying calls. Clients should leverage their positions only when they have conviction about which direction the underlying security is likely to go.

Rather, the stock-replacement strategy is designed to provide exposure with limited risk at a time when there is no conviction. The long call plus fixed-income will act like a convertible debenture, with the call providing equity-like exposure and the bond being the defensive component.

To put some meat on this skeleton, let’s examine a stock-replacement strategy using Bank of America (BAC; recently priced at US$14.35 a share). Although BAC’s stock has turned in some decent numbers recently – rising by 19.3% year-to-date at the time of writing – future growth will hinge on how well the U.S. economy recovers and whether the bank is motivated to lend.

BAC, like all U.S. banks, is contending with enormous regulatory oversight because of its past lending practices. And, like all “too big to fail” U.S. banks, BAC has been reluctant to lend to anyone without a pristine credit rating and ample collateral. Consequently, the U.S. banking system is sitting on US$2.6 trillion in reserves.

The typical multiplier for bank reserves is 70:1. Currently, these reserves are generating about 1.4:1 in economic activity. Without a massive increase in that latter ratio, it’s unlikely we will see U.S. nominal growth get much higher than 2% – and therein lies the risk, as many analysts believe that the U.S. equities markets already have discounted growth well above that range. There are two ways to look at this situation.

The bullish scenario says that when bank vaults begin to open, there is abundant capital to cause a major spurt in economic activity. If we see stronger economic activity and the U.S. Federal Reserve Board begins tapering off its bond-buying program, that should mean higher interest rates, benefiting BAC’s net interest margin. Both would be exceedingly good for the economy’s bottom line and, particularly, for BAC, as it is one of the largest players in the mortgage-origination business.

The bears would argue that banks will not engage in higher-risk loans until they have both buy-in from regulators and comfort that riskier loans will not find their way into loan-loss reserves.

Both scenarios are plausible and, to some extent, dependent on the political will of the U.S. federal government. Hence the logic for a risk-reduction strategy.

Suppose you were bullish on BAC and had a client willing to buy 1,000 shares at US$14.36 each. The total outlay would be US$14,360. For the stock-replacement alternative, your client would purchase, say, 10 BAC January (2015) 15 calls at US$1.52 a share (for a total investment of $1,520). The remainder of the capital that would have been required to buy the 1,000 shares would be used to buy a fixed-income security that would mature in January 2015.

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