Stock Repair Using Options
Even the most successful traders and investors have trades that don’t turn out as expected from time to time. It's perfectly common to make an investment expecting it to increase in value, only to see it drop in value instead, sometimes significantly. This can happen to anyone, no matter who they are and what they are investing in.
When such a scenario does arise, the important thing is to try and minimize the impact of the unexpected loss. On this page we look at what can be done when a stock investment goes bad, and specifically how options can be used to help repair a bad stock trade.
- The Stock Repair Strategy Defined
- When to use the Stock Repair Strategy
- How to use Options to Repair Stock
The Stock Repair Strategy Defined
The stock repair strategy was named as such because of the fact that it basically repairs, or fixes, a trade that is broken. It's a simple options trading strategy that is used to make it easier to recover when a long stock position has resulted in losses due to a drop in the price of the stock, and it's an excellent alternative to some of the other methods that can be used when losing money from a trade.
There are two main advantages of using this strategy: there are no further costs associated and it means that you can recover your losses more quickly if the stock starts to move back up in price. There are only two transactions involved; you need to buy enough at the money call options to cover the amount of stock owned and then write twice as many as out of the money calls. More details on exactly how to use this strategy are further down this page.
When to Use a Stock Repair Strategy
Typically, an investor would consider three possible actions following an unexpected drop in the price of stock they owned: closing the position for a loss, investing more into the position, or holding on to the position until the price rises sufficiently to break even.
The first of these, simply cutting losses by selling and moving on, is a far from ideal solution, particularly if the losses are significant. This is sometimes the only sensible solution if the stock is unlikely to recover. The second possible action, investing more capital to reduce the average cost per share, can be effective in the right circumstances. However, there's always the risk that it's simply throwing good money after bad.
The third possibility is holding on to the stock until the position breaks even, but this can take a long time and may not even happen at all.
The repair strategy offers a number of benefits and should be considered over the above methods for a number of reasons. For one thing, it doesn't require any additional risk, unlike investing more money to reduce the average cost per share. This is particularly useful if you aren't completely confident that the stock will start to rally and increase in price again.
Also, because the strategy reduces the break-even point of the original trade, it's a very effective way to recover losses more quickly than might otherwise be possible if you simply left the position open and hoped that the price comes all the way back to the point that it was purchased.
If you expected the stock to continue to fall, then you would probably be better off cutting your losses. If you do expect that the price will rise again, then the this strategy is very much one that you should think about using.
How to Use Options to Repair Stock
As we have said, this repair strategy is really quite simple and involves placing just two orders. First, you should use the buy to open order and purchase calls with a strike that is equal to the current price of the stock i.e. at the money calls. You should purchase enough contracts to cover the number of shares you own.
Remember that an options contract typically covers 100 shares, so you would basically buy one options contract for every 100 shares that you own.
You'll then need to use the sell to open order and write twice as many calls as you have just purchased. Ideally these should have a strike that is roughly half way between the current price of the stock and the price you purchased it at, and the price of these options should be about half the price of the options you have bought. This isn't as confusing at it might sound, as the example below shows.
You purchased 100 shares of Company X stock at $20 per share, for a total investment of $2,000. The price then drops to $10 per share, meaning your investment is worth just $1,000 and you have effectively lost $1,000.
To use the repair strategy you buy 1 call options contract (covering 100 shares) with a strike of $10. Let’s say the total cost for this is $200. You then write 2 call options contracts (covering a total of 200 shares) with a strike of $15. Assuming these call options were half the price of the purchased options, this would result in a credit of $200 to offset the $200 spent on purchasing the at the money call options contract.
Therefore, this would mean that the trade has cost you nothing (other than commissions, but we’ll ignore those for the sake of this example).
If the price of Company X stock stayed at $10, or dropped even further, by expiration then all the options contracts would expire worthless and you will have neither gained nor lost from using the strategy. Of course, any further drop in the price will reduce the value of your position but that would have been the case whether you had used the repair strategy or not.
If the price of Company X stock moved up to $15 by the time of expiration, then the call options written would expire worthless, but you could exercise your option to buy 100 more shares at $10. You would now own 200 shares with an average price of $15 each (100 bought at $20, 100 bought at $10). With the price at $15 you could close your position by selling your shares and breaking even. Without using the repair strategy, you would still be in a losing position of $5 per share.
If the price of Company X stock moved up above $15 by the time of expiration, to say $20, you would still break even. You would again exercise your option to buy 100 more shares at $10 to own 200 shares at an average price of $15. The call options you wrote would be exercised by the holder, and you would have to sell those 200 shares at $15, giving you a break even position.
It should be clear that this strategy can be a very useful indeed. Although it doesn’t protect you if the stock falls further in price, this would be the case if you didn’t use the strategy at all anyway. The main principle is that the break-even point is lower than if you simply held on to the stock and waited for it to recover.
As you can see from the above example, the break-even point becomes $15 if you use the repair strategy, as opposed to $20 if you don’t. Even if the stock went up, but not as high as $15, you would still recover more losses than you would without using the strategy, because the call options purchased would give you an additional return, but the call options written would expire worthless and you would keep the credit from them.
In summary, if you hold a losing long stock position and believe that the stock will make at least some form of recovery, then we would recommend employing this strategy to increase your chances of breaking even.