Many people have acrophobia -- a fear of heights. The higher they get, the more afraid they are. Some investors experience a similar fear. The higher the stock market moves, the more afraid they are.
This investors' version of acrophobia could be flaring up with the S&P 500 less than 4% below its all-time high. It doesn't help matters that the index's cyclically adjusted price-to-earnings (CAPE) ratio is also near a record high.
What can you do if you don't want to avoid the stock market altogether? This strategy that expert investors use could significantly lower your risk.
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The stock replacement strategy
The stock replacement strategy uses deep-in-the-money call options to replace stock. If that sounds like mumbo-jumbo, don't worry. I'll walk you through what this strategy entails.
First, call options give the owner the right to buy a stock or an exchange-traded fund (ETF) at a specified price (called the strike price) by a specified time (the expiration date). However, the owner has no obligation to buy the stock or ETF by the expiration date.
Note that call options give the right to buy shares in blocks of hundreds. For example, one call option allows you to buy 100 shares of the underlying asset, two call options allow you to buy 200 shares, etc.
Call options with a strike price higher than the current share price of the stock or ETF are referred to as out-of-the-money (OTM). If the strike price is lower than the current share price, the option is referred to as in-the-money (ITM). When the strike price is significantly lower than the current share price, it's deep ITM.
With this strategy, an investor who owns a stock or ETF that has appreciated sells part or all of their holdings and replaces it with deep ITM call options. Ideally, the call option will have a delta (a measure of the sensitivity of the option's price to changes in the price of the underlying asset) close to one. This means the call option will move up or down similarly to the stock or ETF.
The option should have an expiration date well into the future. Long-Term Equity Anticipation Securities (LEAP) options are good picks because their expiration dates are between one to three years out.
How this approach reduces risk
The stock replacement strategy reduces risk by reducing the amount of money invested. Buying call options is less expensive than buying shares of the underlying stock or ETF. However, the approach allows you to still participate in an upward momentum of the underlying asset.
Let's look at an example of how this works. Suppose you've owned 500 shares of the Vanguard S&P 500 ETF (VOO 0.15%) for several years and have accumulated some nice gains. With the S&P 500 near its all-time high, you're getting jittery. You could sell some or all of your shares and replace them with call options.
VOO's price is around $464 at the time of this writing. You can buy a call option on the ETF with a strike price of $295, an expiration date of Jan. 17, 2025, and a delta of 0.9997 for roughly $176. This means you could sell your 500 shares of VOO for around $232,000 and buy call options to replace those shares for around $88,000.
You'd immediately have $144,000 that's no longer at risk (perhaps parked in safe U.S. Treasuries). But if VOO rises, you'll profit close to the same amount as if you owned shares of the ETF. This same approach can be used with any other stock or ETF for which options are traded.
Lower risk doesn't mean no risk
Keep in mind that this stock replacement strategy doesn't eliminate risk. If the price of the underlying asset declines, so will the deep ITM call option.
Options also experience time decay. In other words, the closer to the expiration date, the more the option's value decreases -- even if the price of the underlying stock or ETF doesn't fall. LEAPs give you more time, limiting time decay to some extent. You can also "roll" your call options by replacing them with new options with later expiration dates.
