Because option buyers are not always speculating

Options are risky! A reasonable representation, given that most traders use options to speculate. But hardly accurate. There are many option strategies, both long and short, that actually reduce risk.

The most common risk reduction strategy is covered call writing. Buying the underlying stock and selling a covered call to generate premium income and reduce the cost of the stock position, is clearly aimed at reducing risk.

When looking at the other side of that trade, we usually see a speculator. And there’s the rub… what you see is not always what you get. In fact the call buyer may actually be employing their own version of risk reduction; as in a stock replacement strategy or a synthetic convertible strategy.

Stock replacement strategy

Suppose the call buyer has originally bought 500 shares of Agrium (TSX: AGU) in August 2007 at $50 per share. AGU has since rallied, closing last week at $89.81. Who can argue with a 79% return over one year. The question is do you sell now and take your profits, or hold onto the position looking for further gains.

Most traders have a difficult time deciding when to sell. Always trying to weigh a no win emotional roller coaster. If you sell and take your profit, where do you invest next. If you hold and the stock declines, you feel bad for not taking money off the table. Enter the stock replacement strategy.

The idea is to sell the stock and take your profits, and then replace the shares with a long call option. Using AGU as the example, you would sell the 500 shares at $89.81 and then buy 5 AGU January 90 calls at $11.00 per share.

With a stock replacement strategy you are still in the game with some profits already in your pocket. With the January 90 calls, the most you can lose is the price of the call. If the stock rallies, you participate through to the January expiration.

This strategy makes particular sense if the options are reasonably priced. That is, if the options are understating future volatility, which I think may be the case with the fertilizer companies.

The synthetic convertible

A version of the stock replacement strategy could also be used if you missed the rally in AGU, and are asking yourself if it is time to get in.

Investors trying to make this decision face the same emotional roller coaster as the ones using the stock replacement strategy. Weighing the cost of a missed opportunity, against the risk of buying too late.

The synthetic convertible strategy uses call options to leverage the stock position. Using calls rather than an outright purchase of the stock.

For example, suppose you were looking to purchase 500 shares of AGU at $89.81 per share. Under that scenario, your total investment would be $44,905 (plus commissions).

What you could do is take $5,500 from the $44,905 you were going to commit to AGU, and buy 5 AGU January 90 calls at $11.00. You would then put the remaining $39,405 into a Government of Canada treasury bills that matures in January 2009.

At this point, your portfolio is comprised of two securities, a risk free treasury bill and a call on AGU. Hardly the kind of trade aggressive investors would employ.

What you have in this example, is a lower risk alternative to an outright purchase of AGU. In effect you have created a synthetic convertible debenture on AGU, as the call represents exposure to the underlying stock, with the treasury bill representing the fixed income component.