Recently, (October and November 03), the giant biotech Amgen
(AMGN) came under some intense pressure, trading down about
$12.00 before it found what appeared to be a decent level of
support, and began to consolidate. At this level, anyone
interested in going long Amgen at a discounted price would be
advised to do so. Implied volatility was high coming off this
precipitous drop, which caused premiums in the options to
increase considerably.

This scenario can be a very attractive for covered call sellers
or buy-writers. On Tuesday, December 2, 2003, Amgen was trading
at $58.90, the December 60 call was trading at $1.30, and there
were only two weeks left until expiration.

Lets assume that you wanted to take advantage of this
opportunity but you would be unable to participate in it due to
capital requirements. The stock was trading at $58.90 and you
did not have sufficient funds to support buying the stock at
that price. After all, the purchase of just 1000 shares would
cost $58,900.00.

This is the time to consider using a strategy called stock
replacement. In many instances, an insufficient amount of funds
in the investors account can mean the loss of a golden
opportunity when dealing with high dollar priced stocks.

So, an alternative to purchasing the stock outright is to find a
way to replace the actual stock with something else which is not
as expensive. In this case, a deep in-the-money call would do
just that.

When a call is deep in-the-money, meaning that the strike price
of the call is much lower than the stock price, the delta of the
call approaches 100. This means that there is close to a 100%
chance that this option will finish in-the-money.

Because of this, the option will trade just like the stock;
penny for penny, dollar for dollar (in a theoretical 100 delta
scenario.) If you recall, the term delta was mentioned when
describing the option in question. Delta is the first derivative
of the stock and it has a three pronged definition. The first is
percentage change.

The delta is given as a percentage change, meaning how much in
percentage terms the option price will change with a movement in
the stock. A 50 delta option will move 50% the amount the stock
does. If the stock moves $1.00, than the option moves $.50. A 30
delta option moves $.30 on a $1.00 movement in the stock, and so
on.

Delta can also be defined as percent chance. This is used to
describe the percentage chance that the option will end up
in-the-money. A 90 delta option has a 90% chance of finishing
in-the-money.

Finally, delta can also be defined as hedge ratio which is the
amount of deltas needed to properly hedge a position. These
concepts will be discussed in more detail in future Options
University courses, but for now it is sufficient to just
understand these basic concepts.

It was important to explain the meaning of delta to understand
that the deep in-the-money call would perform and act just like
the stock. One way to determine if the call you will select is
in-the-money enough for your purpose is the delta. A delta in
the mid or high 90s is an ideal candidate.

The selection of the proper in-the-money call to use is a
critical element in the success of this strategy. In order to
obtain an accurate delta of all options under consideration for
stock replacement use, you can go to any number of web sites or
consult your broker. If all else fails, there is a little trick
of the trade that can be used to aid in selecting a call that is
deep enough in-the-money to suit the stock replacement criteria.

To do this, check the quote of the corresponding put (i.e. the
December 47.5 put if you are looking at the December 47.5 call
for stock replacement). If there is no bid quoted for the put,
then the call is deep enough in the money to consider it for a
stock surrogate. There are several reasons for this being an
effective strategy, which we wont cover here, but for the
purposes of this discussion, it is enough to know that this
method does work.

So, with the stock at $58.90, the December 47.5 calls met the
criteria for stock replacement. This call had a mid to high 90s
delta and its corresponding put had no bid. The December 47.5
call was trading at $11.45 or $.05 over parity. By purchasing
this option, you would be equivalently buying the stock at
$58.95 (the strike price plus the option price).

Lets say that you bought the December 47.5 call for $11.45. If
a total of 10 calls were purchased (an equivalent of 1000
shares), you would lay out a total of $11,450 to fulfill your
stock requirement on this buy-write. If you had purchased the
stock outright, you would have spent $58,900. The difference
between the capital needed to purchase the stock outright
($58,900) and the capital needed to buy the in-the-money call
($11,450) is the key to this trade.

Now that you have your stock (via the calls you bought above),
it is time to sell covered calls against this position, which
would be the December 60 calls for $1.30. If the stock stays at
its present level, you would then capture the $1.30 premium that
you sold the December 60 calls for because they finished
out-of-the-money at expiration.

The $1,300 profit in this scenario represents an 11.35% return
in only two weeks. This well out-performs the return garnished
on a $58,900 investment which would only be a 2.21% return in
the two weeks, if you purchased the actual stock.

As we know, the maximum profit of $2.35 will be attained if the
stock reaches $60.00 or above. This return comes from the $1.30
you received in the premium for the sale of the now worthless
December 60 call plus a $1.05 profit from the December 47.5 call
you purchased. With the stock now at $60.00, the December 47.5
call is worth parity, which is $12.50.

You purchased the call for $11.45 thus you received a $1.05
capital gain in the option. This profit of $2350.00 represents a
20.5% return in two weeks verses a 3.98% return in two weeks, if
you had purchased the actual stock.

As you can see, you are getting the same overall dollar return
on much less money - which creates a much higher percentage rate
of return. This is one of the positive leverage effects that the
proper usage of options can provide. When you initiate this
trade, you are buying and selling two different options
simultaneously which is known as a spread. A spread is a trade
which involves the buying of one option against the sale of a
different option simultaneously and will be covered briefly in
the next section.

By buying the December 47.5 calls for $11.45 and then selling
the December 60 calls at $1.30, you are buying the December 47.5
December 60 call spread for $10.15. This type of spread is known
as a vertical spread.