This article originally appeared on Traders Reserve. It is by Dan Passerelli, a former market maker at the Chicago Board Options Exchange and author of Trading Option Greeks. He operates the Market Taker site.
The market has been doing well of late but we know the market can always go down—sometimes fast and furiously. If a stock you hold has been battered, or could be battered, consider this options trading strategy for fixing the damage.
The Stock Repair Strategy
This strategy involves only call options and can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).
The repair strategy works best after a decline of 20% to 25% in the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the options expiration.
There are three benefits the trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money as he still holds the original shares. If the stock continues lower, the trader’s losses will increase. This strategy is only practical when traders feel the stock has hit bottom.
Second, the projected retrenchment is around 50% of the decline in stock price. A small gain may be marginally helpful while a large increase will help but have limited effect.
Third, the investor is willing to forego further upside appreciation over and above the original investment. The goal here is to get back to even and be done with the trade.
Implementing the Stock Repair Strategy
Buy one close-to-the-money call and sell two out-of-the-money calls with a strike price that corresponds to the projected price point of the retrenchment. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. This “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit.
Here’s an example: An investor buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ is trading at $60. The investor believes the stock will rebound to as high as $70 over the next two months.
The trader wants to make back his entire loss of $20 without increasing his downside risk with the 100 shares already owned. The trader looks at options with an expiration corresponding to his two-month outlook, in this case the March options.
The trader buys 1 March 60 Call at 6 and sells 2 March 70 calls at 3. The spread is established cash-neutral.
Bought 1 Mar 60 call at 6
Sold 2 Mar 70 call at 3 (x2)
By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. This chart shows how the position functions if held until expiration.
If the stock rises to $70 a share, the trader makes $20, the amount lost when the stock fell from $80 to $60. So, the trader regains the entire loss in a retrenchment of just half of the stock decline. With the stock above $60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. At that point the trader would be long 200 shares with the stock between $60 and $70 at expiration. If the stock trades above $70, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond the $20 gain.
But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.
Benefits and Limitations of the Stock Repair Strategy
The stock repair strategy is an option strategy that is very specific in what it can and can’t accomplish. The investor considering this option strategy must be expecting a partial retrenchment and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.