Options

Using NDX Calls for Stock Replacement

Investors are rejoicing with every new all-time high in stocks including the one made today by the Nasdaq-100 index which is up another 0.9 percent at midmorning on Monday, January 13.  After a great year in 2019, the Nasdaq-100 is off to another fantastic start.

The Nasdaq-100 Index contains some of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market.

Now that the start of the new year has passed many investors are willing to sell appreciated holdings, but smart investors know it is impossible to reliably pick a top in the market so they’re asking how to realize some profits in their existing Nasdaq-100 index holdings while maintaining upside.  One way to do this is to sell a portion of their Nasdaq-100 holdings while buying NDX call options to maintain upside exposure.  This is called “stock replacement” because the upside exposure generated by ownership of the Nasdaq-100 portfolio is replaced by ownership of call options.

The risk from stock replacement strategies is that the Nasdaq-100 will drift sideways resulting in the options eroding in value and expiring worthless.  Erosion isn’t an issue for owners of the Nasdaq-100 but those owners instead have to grapple with the possibility of extreme losses; the worst that can happen to the buyer of a call option is the option expires worthless but that is the call buyer’s maximum loss.

During midmorning on the 13th, the Nasdaq-100 index was trading at 9048.  An investor who enjoyed great performance last year might find their portfolio overweight the Nasdaq-100 and could sell some with the index at that level.  To replace the upside potential for the portfolio they could buy the 9050 strike NDX call option expiring on March 20 for 248.00.  Those call options would replicate the upside exposure of ownership of the index while limiting the downside to the 248.00 paid for the call options.  Compare that to the downside exposure of doing nothing and remaining long the index.  You can see the relative profit and loss profiles below.

NDX Chart

Above 8800, ownership of the call option is always going to trail the performance of having done nothing and retaining ownership of the index.  The maximum underperformance in our case will be 250 points or the price paid for the call plus the difference between the index value (9048) and the strike price of the call option (9050). 

But below 8800, owning the call will outperform doing nothing and the degree of outperformance will increase as the level of the index continues to decrease. 

The important element for most investors is that the payoff line for the call option turns upward at the strike price, 9050 in our case, so appreciation is maintained.

Buying an NDX call option for stock replacement is a bit like buying insurance; the insurance costs money and that will come out of returns.  But the downside is defined which is what anyone buying insurance is looking for.

Nasdaq publishes articles about important aspects of the NDX option market each Monday and Thursday.  Check back here for our latest post.

You can follow Scott on Twitter: @ScottNations

Performance of an index is not illustrative of any particular investment.  Index returns quoted represent past performance which is no guarantee of future results.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Scott Nations

President of Nations Indexes: Scott Nations is the President of Nations Indexes and a bestselling author. Scott is also a Contributor to CNBC and regularly appears on-air to discuss markets, current economic events, and the outlook for a variety of financial vehicles. Nations Indexes is the world’s leading independent developer of volatility and option enhanced indexes and investment vehicles. The Nations Strategy Indexes, including the Nations NDX PutWrite Index, combine index investing and systematic option strategies to generate superior absolute and/or risk-adjusted return over full market cycles. The Nations Better Beta® Indexes are the first indexes which magnify gains without magnifying losses.
Scott is also the developer of the Nations suite of volatility indexes including VolDex® (ticker symbol VOLI) and TailDex® (ticker symbol TDEX), the first measure of the market’s expectations for a “tail event” or steep drop in prices.
Scott is the author of A History of the United States in Five Crashes, a general interest history of the five modern stock market crashes (1907, 1929,1987, 2008 and the Flash of 2010) which was published by HarperCollins in June 2017. Scott is the author of Options Math for Traders, published by Wiley & Sons in 2012 which was an Amazon.com bestseller. He is also the author of The Complete Book of Option Spreads and Combinations, published by Wiley & Sons in October 2014. Prior to founding Nations Indexes, Scott was a member of the Chicago Mercantile Exchange and was a market maker and floor manager for a leading index option trading firm. While there, he was responsible for development and implementation of proprietary option pricing models.

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