Don’t you hate making a bad call when you go long a stock? It’s happened to all of us. There are many questions to ask as to why you were wrong, but that’s for another article. The question now is what to do about it if you want to try and repair the mistake sooner rather than later.
A lot depends on what you think is going to happen to a stock in the coming months, because your speculation will determine your options strategies. Let’s take on a real-world example with Green Mountain Coffee Roasters (NASDAQ: GMCR). Suppose you bought 100 shares at $70. Today the stock is at $52. Ugh, that’s an $1800 loss.
Maybe you believe that, consistent with previous big drops in the stock, it will rebound to recapture some of its loss. You figure it won’t get back to $70, but maybe it’ll get to $60. First, you buy one May 52.50 call for $4.60. You also sell two May 60 calls for $2.20 apiece. So this costs you around $40 in net premiums.
If the stock returns to $60, you have doubled up on your exposure at very little net cost ($40). You have also recovered $1,550 of your trade, given the advance in the call plus the bounce back in the stock. Not a bad recovery. From there, you can choose to sell out and harvest the capital loss to offset other gains, or perhaps continue to play with options for the next month out.
If the stock craters further, you are out of luck, although at little cost.
Another strategy can be used if you own a stock and the fundamental story hasn’t changed, but you are nervous about doubling down and buying more shares. I have a great real-world example with this. I think First Cash Financial Services (NASDAQ:FCFS) is a great company with a great story. I bought 500 shares at $41 and was bummed to see it fall back to $35.
Rather than invest another $17,500 to double up on my position, I instead sold five of the next month’s 35-strike puts for $1.35. So immediately I collect back $1.35 of my $6 loss. If First Cash rose from there (which it did), I created a nice compromise. I didn’t collect the full benefit of the stock’s recovery, but did capture $1.35 of it. Had First Cash fallen further, I would have had more shares put to me, but at the equivalent price of $33.65. I would then have turned around and sold the next month’s 35-strike calls when the stock approached that strike price again.
As of this writing, Lawrence Meyers owns shares of FCFS. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.