Investors who have suffered a substantial loss in a stock position have been limited to three options: "sell and take a loss", "hold and hope", or "double down". The "hold and hope" strategy requires that the stock return to your purchase price, which may take a long time if it happens at all.
The "double down" strategy requires that you throw good money after bad in hopes that the stock will perform well. Fortunately, there is a fourth strategy that can help you "repair" your stock by reducing your break-even point without taking any additional risk. This article will explore that strategy and how you can use it to recover from your losses.
Defining The Strategy
The repair strategy is built around an existing losing stock position and is constructed by purchasing one call option and selling two call options for every 100 shares of stock owned. Since the premium obtained from the sale of two call options is enough to cover the cost of the one call options, the result is a "free" option position that lets you break even on your investment much more quickly.
Here is the profit-loss diagram for the strategy:
How To Use The Repair Strategy
Let's imagine that you bought 500 shares of XYZ at $90 not too long ago, and the stock has since dropped to $50.75 after a bad earnings announcement. You believe that the worst is over for the company and the stock could bounce back over the next year, but $90 seems like an unreasonable target. Consequently, your only interest is breaking even as quickly as possible instead of selling your position at a substantial loss
Constructing a repair strategy would involve taking the following positions:
- Purchasing 5 of the 12-month $50 calls. This gives you the right to purchase an additional 500 shares at a cost of $50 per share.
- Writing 10 of the 12-month $70 calls. This means that you could be obligated to sell 1,000 shares at $70 per share.
Now, you are able to break even at $70 per share instead of $90 per share. This is made possible since the value of the $50 calls is now +$20 compared to the -$20 loss on your XYZ stock position. As a result, your net position is now zero. Unfortunately, any move beyond $70 will require you to sell your shares. However, you will still be up the premium you collected from writing the calls and even on your losing stock position earlier than expected.
A Look At Potential Scenarios
So, what does this all mean? Let's take a look at some possible scenarios:
- XYZ's stock stays at $50 per share or drops.
All options expire worthless and you get to keep the premium from the written call options.
- XYZ's stock increases to $60 per share.
The $50 call option is now worth $10 while the two $70 calls expire worthless. Now, you have a spare $10 per share plus the collected premium. Your losses are now lower compared to a -$30 loss if you had not attempted the repair strategy at all.
- XYZ's stock increases to $70 per share.
The $50 call option is now worth $20 while the two $70 calls will take your shares away at $70. Now, you have gained $20 per share on the call options, plus your shares are at $70 per share, which means you have broken even on the position. You no longer own shares in the company, but you can always repurchase shares at the current market price if you believe they are headed higher. Also, you get to keep the premium obtained from the options written previously.